Do you invest in the stock market or are you interested in investing your money in the stock market?
Then you need to strike a balance between the risk you take and the reward you can make.
You wouldn’t knowingly invest in something that could only make you $5 but it could lose you $100.
That wouldn’t make sense.
But there are financial products out there that do just that.
And people invest in them.
First Let’s Define Risk
For this article we are going to keep it simple.
We’ll call risk the chance that the outcome is different than we expected.
A Real Life Example Where Risk Doesn’t Equal Reward
You’ve seen this on display quite a bit in real life.
And chances are you didn’t notice.
Have you ever been passed by a driver that crossed a double-yellow line?
I was driving down a country road headed to the lake when a 3-Series BMW flew past me by crossing a double yellow.
He didn’t think I was going fast enough.
But at the next stop sign I pulled up right behind him.
Think about what that BMW did.
He risked his life and the lives of other drivers to get somewhere 5 minutes faster.
The worst outcome would have been multiple people dying in a car wreck.
The best outcome would have been the driver of the BMW getting to his destination a few minutes earlier.
Does that sound like a smart decision to you?
It sounds stupid to me.
Luckily no one got hurt.
This Happens in Business Too
Have you ever heard of anyone that quit their corporate job to follow their passion?
Maybe she loved baking pies and decided to open a bakery.
So she cashed in her life savings to follow her dream.
Except it didn’t turn out well. She lost her life savings and lost her bakery.
I’m not telling you to not follow your dreams.
I’m telling you to be smart about it.
She could have started her bakery out of her house for a fraction of the cost.
Built her business up and then opened the bakery.
The chances of making it would be better that way.
And she would have risked a lot less to make the same potential reward.
Where Does This Occur in the Stock Market?
Now that you have some real life examples, let’s look at stock market examples.
There are one main example that comes to mind when I think about bad risk and reward ideas.
Shorting a stock.
To make it simple, shorting is betting a stock price will go down.
There’s a problem with this. The lowest any stock price can go is $0.
And it’s doubtful that it will reach $0.
But what’s the highest a stock price can go?
You don’t know? Well I don’t either.
A stock price can go as high as it wants.
So you limit your reward and don’t limit your risk.
That doesn’t make sense but many “financial experts” will short stocks and recommend you do so as well.
And just like the BMW driver, it may work out.
It may even work out several times.
But there will be one time you cross that double-yellow and didn’t see that truck coming.
The results will be a financial catastrophe.
So don’t take the risk.
The entire world would be a better place if everyone weighed their decisions based on risk and reward.
Texting and driving wouldn’t happen.
Business ups and downs would be less severe.
And your wallet would be thicker.
So start viewing the world in terms of risk and reward.
Can you think of another real-life example where risk isn’t worth the reward?
If so, let me know how it went in the comments below.
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