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Risk vs. Reward

It’s no secret that greater reward (return) on your investments generally requires greater risk. On the near zero risk of the investment spectrum, which includes treasury bonds and bank accounts, the reward is very low, as exemplified in the current CD rates. On the more aggressive end of the investment spectrum, which includes stocks and junk bonds, the reward has been high since 2009—but so has the risk.

When the stock market crashed in 2008, it was common for aggressively invested portfolios to have lost 30%- 50% or more of their value. Sadly, many of these investors couldn’t afford the loss. Even if they could, I believe there is another aspect of the risk vs. reward scenario that is often overlooked—you shouldn’t risk what you’re unlikely to be rewarded for.

Some of my clients, especially the younger ones, have recently expressed the desire to have some of their portfolio in the stock market. They want a greater reward than the banks are offering and are willing to take the risk. However, the risk/reward ratio is critical. How much potential reward is there for the risk you are taking? If there is no potential reward, why would you gamble on the risk, even if you could afford it?

Consider this: if one of your friends challenged you to get in the ring with Mike Tyson, would you do it? Most likely not. But what if they offered you ten million dollars? I bet you would at least think about stepping in! Why? Because now there is a reward for the risk you would be taking.

So, what is the potential for reward in the stock market? Frankly, no one knows the answer to this question. Your individual investment decisions will depend on your opinion of the economy and current events and what you believe is likely to occur in the near future.

This leaves us with only two choices: the market will either continue growing at this frantic pace and blow through its previous high, or it will not. I meet with investors each day and most of them tell me they think it is more likely that the market will have another major correction, maybe even a 30% or 40% drop, before reaching its all-time high again. Maybe the market will in fact climb back 15% to its all time high. But maybe it won’t.  Instead, maybe it will drop 40% or more, which is what most people believe is more likely.

If you had the option of playing a game where if you won, the best you could do would be to win 15%, but if you lost, you could lose 40% or more, would you play? Most people would not play because the risk would outweigh the reward. This is exactly how I view the stock market today. If you play, there is a chance you might make 15% on your money. But if you lose, you may lose 40% or more.

Where is the stock market today relative to the recent past? In March of 2009, the S&P 500 hit a low of 676; two years later, on April 21, 2011, the S&P 500 reached 1337, just a few points shy of doubling. But what is the all-time high of the S&P 500? On March 24, 2000, the index hit 1553, which means that today it is just 16% away from that record high.