Know Your Risk and Reward
By Scott Chan
You've doubtless heard of the saying, "There's no such thing as a free lunch." It's a cliché, but it's a cliché for a reason. It's true, especially when it comes to Wall Street.
Understanding the relationship between risk and reward is a crucial ingredient to successful trading or investing. Generally, you won't get something for nothing.
For a higher return, you typically have to take on higher risk. If you want something with low risk, you typically have to settle for a lower return. This relationship is clearest when the return is fixed, such as with a fixed-rate bond. If you want higher interest, you have to buy a longer-term bond and/or buy a bond with a lower debt rating (higher default risk).
Expectation vs. Reality
When you are dealing with investments whose return isn't fixed—such as a stock—then you are dealing with expected risk and return.
To buy a growth stock (the company is expected to increase sales and cash flow quickly) you likely have to pay for a high valuation (e.g., price-to-earnings, price-to-sales, etc.).
Value stocks are cheaper in that their valuation metrics are lower, but they aren't expected to grow very much. This means for a growth stock you may have to pay 50x earnings, while for a value stock you pay only 8x.
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Market expectations are not always correct, but in the long run, the risk/reward relationship stands. You won't often find a growth stock that's trading cheaply (low valuation, NOT necessarily low price), unless there were some problems under the hood.
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