When you invest in your business or put your profits into an investment vehicle, you can determine what your potential return is. You must also examine the amount of risk you take. In other words, you could lose all or part of your money. Understanding how potential returns and risk work together can help you evaluate investment opportunities and make informed decisions.
Risk Relates to Value
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When any given investment opportunity seems to have higher risk than other opportunities, its value may fall. The reason for this is that investors expect to be compensated for taking on extra risk. If they could put their money in a safer investment at the same price, they wouldn't consider the risky investment. However, if they receive a discount, they may be willing to put their money to work in an opportunity. For example, if you own a start-up business that the bank considers a risk for failure, it may loan you a reduced amount than it would a large corporation, because your company has less value.
Returns and Risk
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The higher the risk for an investment, the higher the potential returns. Any time you want to make a higher percentage rate or capital gain than most people make, you have to consider taking on more risk. That's why bonds of companies with bad credit ratings pay higher interest. The company could fail and the bonds could become worthless. A nice, steady investment in a blue chip stock historically yields lower returns than the stocks of successful start-up companies. If you decide to invest in a joint venture, you can evaluate the risk involved. If that risk seems high, you can ask for a guarantee of higher returns by getting a better percentage of profits to compensate you for taking the risk.
Balancing Investments
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You don't have to take on high risk for an entire portfolio. Instead, you can spread the risk by putting money to work in safe, moderate and risky investments. The percentages you decide upon are up to you, but you can tailor your mix to your own risk tolerance. This approach gives you the opportunity to make exceptional gains on riskier investments, while keeping a portion in safer investments that pay a lower return. In the event your risky investment fails, you will have some funds to use for recovery.
Debt and Risk
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You must know the debt of any company you invest in. Whether you buy stock in a company, purchase corporate bonds or sink your money into a new venture, excessive debt can undermine your investment. To put it simply, the company must earn enough to make a profit after making debt payments. Failure to do so will result in company failure. Investments that look like they could offer high returns may be masking the fact that the company has been growing by borrowing. The higher the debt, the higher the risk of failure.
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The article emphasizes the critical relationship between potential returns and risk in the realm of investments. Here's a breakdown of the key concepts:
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Risk and Value: The article highlights that when an investment opportunity carries higher risk compared to others, its perceived value may decrease. Investors generally expect compensation for taking on additional risk. For instance, if a start-up business is considered risky, a bank might offer a reduced loan amount due to the perceived lower value of the company.
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Returns and Risk: There's a direct correlation between the level of risk and potential returns. In order to achieve higher returns, investors often need to accept higher risks. This is evident in the example of bonds from companies with poor credit ratings—they offer higher interest rates to compensate for the increased risk of potential failure.
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Balancing Investments: The article suggests that investors don't have to expose their entire portfolio to high risk. Instead, they can diversify by allocating funds to safe, moderate, and risky investments based on their risk tolerance. This approach allows for the possibility of exceptional gains from riskier investments while maintaining a safety net with lower-risk options.
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Debt and Risk: An essential aspect highlighted is the importance of understanding the debt of any company before investing. Excessive debt can undermine an investment, as the company must generate enough profit to cover debt payments. Investments that appear promising might actually be masking high debt levels, increasing the risk of failure.
In summary, the article provides insights into the intricate relationship between risk and returns, the impact of risk on investment value, the correlation between risk and potential returns, the strategy of balancing investments based on risk tolerance, and the significance of assessing the debt of companies before investing. These principles are fundamental to making informed investment decisions in a dynamic financial landscape.
