LET’S SAY YOU want to start a new business. FastFish – the Uber of fish and chips – is aimed at people who want Britain’s most famous dish delivered to their door within 15 minutes of frying. You think there’ll be a big demand, but you don’t have enough money to get your idea off the ground.
You have two options to turn your dream business into reality:
1. Option one is to borrow money from a bank through a small business loan where you pay back the principal over time with interest.
2. Option two is selling equity in the business to family, friends or outside investors where they are entitled to a portion of the business’ profits and the proceeds if the business is sold or goes public.
There are pros and cons to each funding option. If FastFish does wonderfully, there is huge potential upside for anyone who purchased an ownership stake to earn higher profits or see the value of their ownership stake increase. A lender, on the other hand, is only going to make the agreed upon interest income payment and get their principal repayment when the loan comes due.
If, on the other hand, FastFish does terribly, there is a huge potential downside for anyone who purchased an ownership stake to see lower profits and the value of their ownership stake fall or even going to zero in the worst-case scenario. A lender, on the other hand, is legally obligated to their debt repayments and would be first in line for any payments or asset forfeitures before the stockholders in the event of a bankruptcy – if people decide fish and chips on demand isn’t something they’re interested in.
Financial assets have a similar risk profile. Investing in stocks offers big potential upside but it comes at the risk of big downside potential. Owning high-quality debt or bonds lowers the risk of large losses but that protection is offset by the fact that your upside potential is capped. Cash flows paid to the owners of stocks are also far more volatile than those for bondholders because corporations have their own unique business risks and can get into trouble if the economy struggles.
There is no right or wrong answer in terms of how you deploy your capital between being an owner (stocks) and being a lender (bonds). But, how you allocate your money between the two is one of the most important decisions you will make as an investor because it sets the tone for your portfolio’s risk profile.
If you only understand one concept about the risk of investing your capital, let it be this: you cannot earn high returns on your money over the long run without accepting losses or bone-crushing volatility at times. And you cannot keep your money safe from losses and bone-crushing volatility over the short run if you’re not willing to accept lower returns over the long run.
Risk never goes away completely, it just gets transferred somewhere else. This is the essence of risk and reward when investing your savings.
Understanding risk and reward in the stock market is the subject of our next chapter.