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How the Market Works

How the Market Works and Why You Care: Risk vs Reward

Posted by kdadmin on October 12th, 2015.

How the Market Works and Why You Care: Risk vs Reward

Successful investors know how to balance risk and reward.

The graph above shows how the stock market (SPY) and the bond market (AGG) have performed since the Fed made their interest rate announcement in mid-September. What do you notice?

First, you notice that the total performance was about equal. Second, you notice that the stock market (SPY) went WAY DOWN in the middle, whereas the bond market (AGG) stayed relatively steady. Now, if you had invested your life savings in the markets, which investment would you have preferred?

This chart perfectly illustrates risk management. The standard deviation(how much an investment is likely togo up and down over a given period of time) for SPY is about 10, but for AGG it is about 3. If both investments have the same result over a given period of time, smart money buys the less risky investment because there is a lower chance of loss. This is how the market works.

Suppose, for example, that you needed money on September 28. If had bought SPY, you would have lost 5.5% on your investment. If you had bought AGG, you would have made about 1%. Now, AGG could have gone down as well, but it’s lower risk means that you’re less likely to experience a substantial loss should your investment needs change.

Bottom Line: Take only the risk you need to accomplish your objectives. If you only need a 4% return to Live the Life You Love, you would only take enough risk to reach this level. If you needed a higher return, you would take proportionately more risk. There is no reason to “risk it all” when you already “have it all.”

p.s. If you’re foggy on how bonds work, start with my post, How the Market Works and Why You Care: Bonds 101.

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