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Course: Financial Literacy > Unit 7
Lesson 2: Risk and return of investment optionsWhat is risk and return?
Risk and return are two important parts of investing. Risk is the chance that you might lose money, while return is the money you make from your investment, and usually, investments with higher risk have the chance for higher returns. Created by Sal Khan.
Want to join the conversation?
- I know this is a weird question, but at what point does it not count as an investment? If I buy $200 worth of lottery tickets, (don't worry I don't actually buy lottery tickets), would it still count as an investment because of the 0.00000000001% (or however much it is) chance that you become a millionaire?(2 votes)
- With lottery tickets and casinos, it's random, and the house has the edge. You can calculate the odds or somebody has done so for you, and at the end of the day, in aggregate, the casino or the state is the one coming out ahead. (In cases where a skilled blackjack player is counting cards and therefore creating an edge for him/herself, the casino will usually show that person the door.)
With investments, although there can be a lot of randomness, you're buying something of value and you can reasonably expect that value to go up, at least most of the time. If you buy a stock, you own a little slice of that company, and you own it because you expect that company to earn a profit, and eventually, for that profit to increase. Many stocks also pay dividends. If you buy a rental house, that house has value. You could sell it for money, and possibly with improvements and appreciation, you could sell it for more than you paid. The rent that the tenant pays also creates income, which is value for you.(2 votes)
- Hi, on later lessons no one chats(0 votes)
- OK, you made me look, and on the following two lessons I found several questions and responses. I urge you to look again.(1 vote)
Video transcript
- So probably the main thing
you'll hear when you talk about investing is what
is the return that you got on your investment? And return on investment is oftentimes people will say ROI, and there's a lot of different
ways of calculating it, but maybe the most basic ways, think about if you put a hundred dollars into an investment this year and then next year you got back $110. So you got a $10 return on top of your $100 that you invested. People would say that
you got a 10% annual ROI or 10% return on investment annually. Now, it can get more complicated depending on what type of an investment it is and how it pays you out
over time, et cetera. But ROI is a really good
thing to think about. Any investment you make,
generally speaking, you might say, "All right, if there's one
thing that gives me a 20% ROI or return on investment, that's better than something that gives me a 10% ROI." And if in terms of risk,
they're similar, the same, then that might very well be the case. But it turns out that there's usually a trade-off
between risk and return. You're usually not going
to get a higher return for something that is equally as risky. If that were the case, everyone
would invest in that thing and not the thing that's
giving the lower return. And so to just give an example of how you see that in the real world, you can think of very,
very, very safe investments. For example, if you just have your money in a savings or checking account you might get low single
digits, 1, 2, 3% on your money depending on where interest rates are, which doesn't feel like a lot, but it's very, very, very safe. If it's less than $250,000 per person, per account type, well, then you are pretty much guaranteed to get your money back. So low risk and arguably low return. If you're to go slightly higher risk, you could do something like
lend to the federal government. You lend to the federal government
by buying treasury bonds and treasury bills,
oftentimes T bills for short. Now those are pretty much guaranteed to pay you what they say they're going to pay you. So you say, "Okay, why do I
get slightly higher interest for that than I get on
my checking account?" Well, it's a little bit less convenient if you need your money right that second. Yes, you could sell those
treasury bills or treasury bonds, but those prices do fluctuate. So you're only guaranteed to
get the money plus the interest if you hold it all the way to however long that treasury bond or
treasury bill was for. It might be for one year, two years, or 10 years or whatever it is. And so there's a certain risk, not just for the price fluctuations, but also how accessible is that money, for example, in that
checking or savings account? If you want that money, you can usually get it within a business, within a working day,
usually in a matter of hours. If you have a treasury
bond or treasury bill, it's a little bit more complicated and you're going to have more
of those price fluctuations. Now, if you wanted to go up
the risk and return ladder a little bit more, well, you
could lend to other entities. You could lend to big, safe companies. They will pay you higher interest than the federal government will. But there's a little bit more risk that they might not pay that loan back. Maybe they go outta business, maybe something dramatically negative happens to their business. And what you'll generally see
as you go to rescuer, sorry, if you go to riskier and riskier companies they're going to pay
higher and higher interest on their bonds. And if you look at the stock market where you're actually buying a share, when you buy a stock where you're buying a piece of the company, you'll normally see that the companies that feel pretty risky, you might feel like they
could have a higher return, but they could also have a
much higher loss as well. While companies that are
safer, generally speaking, you would expect to have lower
risk and also lower return. So it's important to think about return on investment
when you make an investment. And it's very, very, very, very important to think about risk. I can't stress this enough, how many people I've
explained they're like, oh, I have a 30%
guaranteed ROI investment. I'm like, okay, someone's lying to you. Because if it was 30% ROI guaranteed you would have all of the
major investment funds in the world just investing in that. Why would they let little
old Sal invest or you, uncle, why would they let you invest in that if it was really 30% guaranteed? I would be very skeptical of people who say something like that. There's usually a risk that that person isn't thinking about, or that return is in some
ways shady or fabricated, which also makes me feel that that whole proposition
is even riskier. So there are definitely ways that you can get 10, 20, 30% return, but it's usually associated
with a decent dose of risk. And when you go into something like that, also think about the worst case scenario. It's easy to dream about, I'm making all the money, but think about what would happen if you lost 30% or 50%
or 80% of your money? How would you feel then? And then invest accordingly.