Understanding the Concept of Risk & Return

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What Is Risk & Return in Investing?

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Hi! Welcome to Pave Academy’s second module. This module will focus on the investing fundamentals you need to know. Let’s start with an important pairing, risk and return.

In the investment world, risk refers to the possibility of losing money or not achieving your expected return. There are various types of investment risks, such as equity market, interest rate, inflation, and geopolitical risk, to name a few. The key is understanding and managing these risks to strike a balance that allows you to pursue your financial goals without additional stress.

On the flip side, we have return – the reward you receive for taking on risk. In the investment world, return refers to the profit or loss you experience from your investments. There is no return without risk, but there is definitely risk without return. Generally, the higher the potential return, the higher the risk associated with an investment. The greater the potential reward, the more significant the risks involved.

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Navigating the Balance between Risk & Return

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To navigate the delicate balance between risk and return, consider the following strategies:

Diversification: Don't put all your eggs in one basket. Diversify your investments across various asset classes, such as stocks, bonds, and commodities. For stocks, diversify across sectors and even industries. It is also good to diversify your investments across geographies such as Europe or Asia, for example, to spread out the risk.

Risk tolerance: Know your risk tolerance – how much risk you're willing and able to handle. This tolerance depends on your age, financial situation, and investment goals.

Time horizon: Consider your investment time horizon – the time you plan to hold your investments. Traditionally, the longer your time horizon, the more risk you can afford to take.

By understanding and managing risk and return, you'll be better equipped to make informed investment decisions and reach your financial goals. Remember, investing is a journey, and learning to navigate the world of risk and return is a crucial step on the path to success.

The next lesson helps you gauge your risk tolerance and talks about helping define it – you definitely want to stick around for that!

How to Assess Your Risk Tolerance

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What Is Risk Tolerance?

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Now that we’ve understood risk tolerance, we will explore the art of assessing your risk tolerance and capacity.

Risk tolerance and risk capacity might sound like twins, but they're more like cousins. Risk tolerance is your emotional comfort level with taking on investment risks, while risk capacity refers to your financial ability to withstand those risks. Understanding the difference and finding the sweet spot between the two is essential for building a portfolio that suits your unique preferences and goals.

Correctly assessing your risk tolerance will parallel the amount of anxiety you will experience in dealing with your investments. If you assume too little risk relative to how much of a return on your money you have targeted, you will likely end up disappointed with the amount of capital you have at the end of your investment holding period. On the other hand, if you take on too much risk relative to your personality or your finances, any losses that will occur throughout your investment journey could cause unnecessary worry that spills over into other aspects of your life. Understanding your risk tolerance is crucial for building a portfolio that suits your unique preferences and goals.

It's important to assess your risk tolerance before making any major investment decisions and to revisit it periodically, especially during significant life events like starting a new job, taking on a student loan, getting married, having a child, or nearing retirement.

Here is an essential consideration that differentiates a successful investor from the rest of the crowd. Before you enter into any investment, think about how much you could make and how much you can lose. You can only survive as an investor with that mindset.

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How to Assess Risk Tolerance.

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So, how do you assess your risk tolerance? Let's dive into a more detailed process:

Self-Reflection: Assess your emotional reactions to market fluctuations and potential losses. Do market downturns make you anxious, or can you remain calm knowing it's part of the process?

Financial Goals: Consider your investing goals and time horizon. If saving for a short-term goal, you should be more cautious, whereas long-term goals might allow for a higher risk tolerance. Also, consider the importance of each goal and whether you're willing to take on more risk to achieve it.

Risk Capacity: Evaluate your financial situation and your ability to absorb losses. What is an acceptable loss in a month? Over a year? Remember, risk capacity should align with your risk tolerance to ensure you make the right investment choices for your unique situation.

Risk-Return Trade-off: Understand the relationship between risk and return. Taking on more risk can lead to higher profits but also increase the chances of losses. Determine the level of risk you're willing to accept for a specific level of return.

Investment Experience: Consider your past investment experiences and how they have shaped your risk tolerance. If you've experienced significant losses in the past, you might be more risk-averse, while success in riskier investments may make you more comfortable with taking on risk.

Professional Advice: Consulting a pro can help you better understand your risk tolerance and provide personalized guidance on building a suitable investment strategy.

How you weigh these risk tolerance factors changes depending on your situation and financial goals. However, no matter who you are, risk capacity must always be at the top of your considerations for risk tolerance. Ideally, your risk tolerance should grow over time as you gain confidence in your investment process. Too often, people enter the investment world with too much confidence and insufficient analytical capabilities. That is not a recipe for success.

Here at Pave, we help automate assessing that risk, and our suggestions even consider ways to minimize your investment risks. With Pave's easy-to-use tools, you can understand your risk tolerance and build a tailored investment strategy to meet your financial goals.

Different Types of Investment Accounts

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Liquid vs. Illiquid

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This topic will dive deeper into investment accounts, focusing on liquidity and its connection to risk and reward. Our previous episode discussed risk tolerance and its impact on your investing goals. Today, we'll explore another crucial aspect to consider when building your investment portfolio: liquidity.

Simply put, liquidity is the ease with which you can convert your investments into cash. The same concept applies to several types of investment accounts.

Liquid investments can be converted into cash quickly, often within hours or days, and at a price similar to their last stated value. Examples of liquid investments include savings accounts, money market accounts, various types of bonds, stocks, and even commodities or bitcoin. While these investments have different risk characteristics, they all share the attribute of being liquid.

On the other hand, illiquid investments are assets that can't be easily converted to cash in a matter of days or at a price similar to their current value. Examples of illiquid investments include real estate, collectibles like cards or watches, and alternative investments such as hedge funds or private equity.

So, why does liquidity matter? Well, depending on how long you plan on retaining an investment will change how you approach its prospective liquidity. For instance, if you need to access your funds on short notice, it's wise to lean more toward liquid investments. However, if you are in it for the long haul and can afford to tie up your money for an extended period, illiquid investments might offer the potential for higher returns.

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Connection between Liquidity & Risk

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So, let's talk about the connection between liquidity and risk. Generally speaking, more liquid investments tend to be less risky than their illiquid counterparts. That's because they can be bought and sold more easily, giving investors the flexibility to respond to market fluctuations. That does not mean you should buy natural gas futures just because they are very liquid and, therefore, you assume little risk is involved. Natural gas prices can increase or decrease by 5% in just a few hours. Additionally, events can also introduce significant risk. As such, you must know the risks you assume if you buy an incredibly liquid stock such as Apple or Google only minutes before they announce their quarterly earnings.

On the other hand, illiquid investments often come with a higher degree of risk, as they can be harder to sell and may have more significant price fluctuations between the time you decide to sell and when you do sell the asset.

It's essential to balance liquid and illiquid investments with considerations around your risk tolerance, financial goals, and need for accessible funds. Diversifying your portfolio by including a mix of liquid and illiquid investments can help you manage risk more effectively and achieve a well-rounded investment strategy.

In conclusion, understanding the concept of liquidity and its relationship with risk and reward is crucial in building a tailored investment portfolio. By carefully considering your risk tolerance, investment time horizon, and the mix of liquid and illiquid investments, you'll be better equipped to navigate the fascinating world of investing and create a strategy that aligns with your unique needs and preferences.

Types of Investments

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Cash Investing

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Hi everyone! Welcome back to another section of Pave Academy. Today, we'll give you an in-depth introduction to the various types of investments. We'll explore stocks, bonds, mutual funds, and ETFs and see how they all fit into the big picture of your investment portfolio. So, let's jump right in!

Our previous episodes discussed liquidity, risk tolerance, and their relationship to your investment choices. Now, it's time to explore the details of the investment options you have at your disposal.

Let's start with cash. Imagine you've got $1,000 in your savings account. It's the safest option, but it only provides a little appreciation over time, and you may end up worse off after inflation, as we've mentioned before when discussing risk and return. Cash is essential for emergencies or short-term needs, but you'll want to look into other investment options for long-term goals.

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Bond Investing

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Next up, bonds. Bonds are debt securities issued by corporations, governments, or municipalities. When you buy a bond, you loan money for a specified period at a predetermined interest rate. Debt securities are like a promise that someone makes to give you money back if you lend them some. For example, when you buy debt security from a company or government, they promise to return your money later. Before that maturity date, you will receive an interest payment every six months. Now, there are various types of bonds that you should be aware of, including:

• Government bonds: Issued by national governments, these bonds are generally considered low-risk investments. Examples include U.S. Treasury bonds, U.K. Gilts, and German Bunds.
• Municipal bonds: Issued by state or local governments, these bonds finance public projects and are usually exempt from federal taxes, and many of those bonds are exempt from state taxes.
• Corporate bonds: Issued by companies to fund their operations or expansion plans, corporate bonds tend to offer higher interest rates than government bonds but also come with higher risks. The healthier the company’s finances and competitive position, the more likely it will still be in business when you expect to be paid back, and those companies can borrow at more attractive rates than companies that may not have a steady profit outlook. There are rating agencies that help you analyze individual bonds, we’ll delve into this in more detail in future modules.

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Stock Investing

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Now, let's talk about stocks. Stocks are a way to own a tiny piece of a company. When companies start up and want to raise money, they can issue bonds where they do not give up any ownership but need to repay the money given to them. Alternatively, they can issue stock, giving up a certain amount of ownership but investing the money without worrying about ever having to pay it back, nor do they have to pay interest back on that money. That is how stocks work - people buy tiny pieces of a company, and if the company does well, they can participate on the upside. This approach is different from being a bondholder, where you know how much you will make from the company and when you will receive your money, but you trade off any big profits for the certainty of a payoff.

Suppose you buy Apple and it continues to grow and develop new products or reaches new markets and customers, or the general economy improves, and people feel even more confident in Apple’s prospects. In that case, the price of its stock rises. If you had invested $100 in a fractional share of Apple and the stock rose 10%, your investment would now be worth $110. Stock prices fluctuate daily, but if you find a good company and hold it, there is the possibility of sharing in the growth potential of that company.

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Mutual Funds

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Let’s talk about mutual funds. A mutual fund is a mix of different investments based on the plan or mandate of the fund. Instead of buying just one stock or bond, which could be risky if that investment fails, the mutual fund manager buys many different stocks and bonds. That way, if one investment doesn't do well, the others can make up for it.

The mutual fund manager can change the stocks or bonds in the fund, or adjust the amount of a particular stock or bond. For this service, the manager will charge an added fee in addition to the price of investing in the fund. Like any competitive service, some mutual fund managers deserve the fee they charge for their investment ability. However, research has shown that most active managers underperform the general market.

Stock prices move up and down, and most stocks rise or fall based on general business conditions that affect all stocks. Identifying the stocks that outperform the market is determined by a manager’s skill. Sometimes, entire groups of stocks go up more than the general market. If you had decided to invest in a mutual fund focused on technology companies, the fund might hold shares of Apple, Microsoft, Amazon, and several other tech giants. So does that make a manager who chooses those stocks superior to others? In general, the answer is no since his mandate was to invest in big tech companies anyway.

However, your choice of investing in that mutual fund exposed you to a group of stocks that did well. Therefore, if you own some parts of all these companies through a single investment, it provides diversification and potentially reduces risk. One key to investing is diversification. The key to good investing is knowing what types of stocks can out perform as market conditions change. That is the mark of a good manager.

Why are we even discussing something as unimportant as fees on a mutual fund? It’s because fees are important–they take away from your return, which means they reduce your overall performance. And to pay fees for a fund that is not enhancing your portfolio’s performance adds up every year across your investment horizon. That can end up preventing you from reaching your goals.

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ETFs

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Lastly, we have ETFs or Exchange-Traded Funds. An Exchange-Traded Fund or ETF is similar to a mutual fund but typically does not have an active manager; that is why ETFs are often referred to as passive investing because the mix of stocks in the fund is not adjusted as actively.  

The ETF allows investors to buy a bundle of different investments with a smaller fee than a mutual fund. When you invest in an ETF, you choose which stocks or bonds you want to put into your investment“ experience, and it can be as specific as buying gold (GLD)  or 7-10 year U.S. Treasury bonds (IEF), or as broad as 3000 stocks comprising the Russell 3000 index (IWV).

Suppose you're interested in investing in renewable energy but want to avoid picking individual stocks. In that case, you could invest in a renewable energy ETF such as TAN for a diversified portfolio of solar energy stocks. This way, you gain exposure to the entire sector or industry without the need to research and select individual companies.

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Differences between Mutual Funds & ETFs

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Differences exist between ETFs and mutual funds other than lower fees.

Mutual funds are bought and sold through the mutual fund company at the end of each trading day, and the price you pay or receive for a mutual fund is based on the value of the underlying investments at the end of that same trading day.

Conversely, ETFs are traded on stock exchanges through out the day, just like stocks. So, the price of an ETF can change throughout the day based on supply and demand.

In terms of management, mutual funds are actively managed by a professional fund manager.

With all these options, deciding which investment is best for you can be overwhelming. That's where Pave comes in. Pave is an automated solution that helps customers choose investment options based on their unique financial goals and risk tolerance. By considering factors such as your investment time horizon, liquidity needs, and risk capacity, Pave can help you build a tailored investment portfolio to achieve your financial objectives.

Diversification & the Importance of a Balanced Portfolio

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Background to a Balanced Portfolio

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Welcome back! Today, we will discuss asset allocation, diversification, and the importance of a balanced portfolio. So, we mentioned diversification and asset allocation, but what do these terms mean? And how do you apply these concepts to your unique financial situation? The truth is each person has their own risk tolerance, investment preferences, and investment time horizon. That's why creating a balanced and diversified portfolio tailored to your needs is essential. Historically, the general advice was to have a 60/40 split between stocks and bonds. However, as we may move into an inflationary economy, bonds no longer act as a consistent counterbalance to stocks, so the right split is unique to each individual. In building a personalized portfolio, it is also important to mitigate single-asset risk, so it's a good idea only to let any single asset comprise up to 10% of your portfolio.

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The Importance of Diversification.

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Now, let's talk about diversification. By understanding how each investment reacts to market volatility, interest rates, and overall economic conditions, you can create a portfolio with less volatility than any single investment alone. For example, consider a portfolio containing oil and gas and technology companies. Since these two sectors tend to perform better in different economic environments, the combined portfolio will likely have less volatility.

Because there are times when technology stocks and energy stocks go down together, you would want something that may do relatively well in that situation, so you may consider healthcare or consumer staples. More on that later, but you get the idea–you want a portfolio insulating you from adverse events.…

Similarly, when you're building a bond portfolio, the quality of the bonds you invest in matters. If you combine stocks with bonds, you'll typically create a more diversified portfolio. However, if you invest in high-yield or low-quality bonds, they may behave more like stocks, which could lead to less-than-ideal outcomes during periods of market volatility. Sometimes, you want to seek that risk, such as when the economy is doing very well, but you need to know the additional risk to see the investments appropriately.

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Building a Balanced Portfolio

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So, now you're wondering how to build a balanced portfolio tailored to your unique needs. Well, that's where Pave comes in! Pave offers an automated solution that helps you choose the best investment options based on your risk tolerance, investment preferences, and time horizon .If there are any industries you would rather not support by investing in them, our app allows you to eliminate them, making your portfolio truly personalized. Using Pave, you can take the guesswork out of building a smart, diversified portfolio.

There you have it, folks! A deep dive into asset allocation, diversification, and the importance of a balanced portfolio. Remember, one size does not fit all when it comes to investing. So, take the time to understand your unique financial situation and craft a portfolio that reflects your individual needs.

Dollar Cost Averaging: Another Way to Diversify

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What Is Dollar Cost Averaging?

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As we wrap up our journey through investment strategies, we've saved a unique strategy for last. Today, we're exploring the concept of Dollar-Cost Averaging or DCA.

DCA is an investment strategy where you consistently invest a fixed amount of money in a particular investment over regular intervals, regardless of the asset's price.

Like any consistent practice, it involves discipline and patience, but why should we consider it?

You see, markets can be unpredictable. By investing regularly, you're spreading out your investments, which can help smooth out the highs and lows. When prices are low, your fixed amount buys more. When prices are high, you buy less. When you buy all at once, you open your self up to more volatility in your portfolio.

The beauty of the DCA is that it helps mitigate risks from market volatility and removes the pressure of timing the market perfectly. But remember, it requires discipline and a commitment to invest regularly, especially when the market is down.

There is a practice used by many sophisticated investors when purchasing a stock for the day called Value-Weighted Average Price, or VWAP for short. If you decide to buy a stock today before the market opens, you can enter a VWAP buy order. That means it will buy your stock throughout the day, filling your order in full by the time the market closes.

However, the amount of stock that is purchase dat any particular point during the day is based on the amount of trading activity. The first and last hour of the day is the busiest, and trading volume dies down during lunchtime. So, most of your order is completed from 9:30-10:30a.m. and 3:00-4:30 p.m. ET.  Some will be purchased at mid-day, but much less at that time. This staggering avoids the situation of buying when a large buy order could have been placed right before yours, pushing up the price of the stock temporarily and giving you what is called a “bad fill.”

Of course, you could get lucky and buy before a great piece of news is released, giving you a quick profit. However, if you have been following us through the Pave Academy modules, you know that our belief is to rely on consistency and a logical process rather than random events. Over the long haul, you will be better off by following that investment principle.

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Conclusion of Module

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As we close the chapter on this suite of investment strategies - from the contrasting worlds of Active and Passive investing, the dual narratives of Growth and Value investing, the time-bound paths of Long-term and Short-term investing, and now the measured approach of Dollar-Cost Averaging, it should be clear that there is no single 'right' way to invest.

Your investment journey can be as unique as you are, combining elements from these strategies and tailoring them to fit your financial goals, risk appetite, and life situation. At Pave, the platform is designed to guide you through this financial maze right from signing up. We ask targeted questions to understand your unique goals and preferences, ensuring we provide the most personalized guidance possible.

Up next in Pave Academy are investment accounts. We'll unpack different investment accounts, from brokerage to retirement and education savings accounts.

So, gear up for the next exciting module. Let's continue this journey together, paving your path toward financial empowerment. Stay tuned!