Risk and reward introduction | Finance & Capital Markets | Khan Academy

Whenever people talk
about investing, the terms risk and reward
tend to come up a lot, and they usually tend
to come up together. Somehow implying that
the more risk you take, the more reward that
you might be able to get. And that's actually
what it is implying. But what I want to
do in this video is give a little bit of
an introduction to that, or a little bit of context,
and a little bit more structure on how do you
think about risk and reward. So let's say that
we have $1,000, and we want to figure out what
we can do with this $1,000. Well, one option
is we could just put it into a savings account. So here is one option. So we could put it
into a savings account. And in this situation,
our reward– I'll start with
the reward first– is we'll get– I don't
know– 1% in interest per year, 1% annual interest. So after a year, we'll
have roughly $1,010. We got 1% on our $1,000. So we get a little
bit of a reward. What's our risk? So the risk here–
I'll write risk in a different color–
what is the risk here? Well, if I'm putting it
into a savings account– and I'm assuming I'm putting
it into an FDIC insured savings account.

Let me put that over here. If you do open a
savings account, it should be FDIC insured. That means that it's being
insured by the Federal Reserve. Which means that if
for whatever reason that bank were to
fail, below some limit, the Fed will insure your money. So even if this
bank fails, and it loses all of its
money and everything, you'll still get
your deposit back. So if you're
investing, or if you're putting money in an FDIC
insured savings account, your risk is essentially 0. You are guaranteed to
get that $1,000 back, regardless of what
happens to that bank. So you have very
little risk there. But you might say, look, you
know, this is a good risk, but I feel like I can get
more than 1% on my money, let me think about the other
places that I could invest it. Well, you could–
and obviously I'm not going to be exhaustive on
all of the different investment options, I just want to give
you a sense of risk and reward.

You could say, well, maybe
I could lend to the money to a very reputable company. So let me say, lend money
to reputable company. And maybe this company
has billions and billions of dollars in assets. It's been around for
hundreds of years. It generates cash
on a regular basis. There's really very
few circumstances in which you could imagine
that this company would not be able to pay off its debt. And you lend money to
a reputable company by essentially
buying their bonds. When you buy a
company's bonds, you are lending money
to that company. So that's just the way
you should think about it. So the reward here, if you lend
your money to this company, they will pay you 6% in annual
interest on your $1,000. So 6% on the first
year, you'd get $60. This is six times
more than what you were getting in the
savings account. What's the risk here? Well, it's not 0 anymore.

It's not FDIC insured. The Federal Reserve isn't
saying that they'll either give the money if the
bank goes out of business, or they'll print the money
if they don't even have it. Here, the risk is that the
business defaults on the loan. So the company itself
might go bankrupt. If it goes bankrupt,
then all the people that the company
owes money to will go after that company's assets. But maybe you are low
on the pecking order, or maybe the
company doesn't have enough assets to
pay everyone back. So there is some risk. Any business could
go out of business, you never know
what might happen. But since this is a
very reputable company, and as we said it
has a lot of assets, it has a very stable business,
it does good in boom times and in recessions, this is a
low risk of business default. So I'll write, low
risk, right over here, because we're assuming it
is a reputable company that has a lot of assets,
and all the rest.

Now let's say that even that
6%, you know, it's all right, but you feel like
you could get more. You could do better. So let's say that
you have a friend who is a– let's say that
he's just starting his career as a doctor, so he
says he has a nice, stable job. So he's just starting his career
as a doctor, so stable income. He's making $200,000 a year. But he's just out
of medical school, and he figures he
wants to buy a house. So he's just
starting, and he wants to find people who can help
him with the down payment on the house. So here, your reward. And he says, anyone who's
willing to lend to me, I will give them 8% annual
interest on their money. And it looks pretty good,
stable income, it's only $1,000. He's not buying an
outlandishly expensive house. He's buying a $200,000
house on which he wants to put a
$40,000 down payment. Seems well within
his means to pay it. But there's always some
risk that he doesn't pay.

Who knows? Hopefully this doesn't
happen, but maybe something happens to him, himself. Maybe he's not able
to work as a doctor. Maybe something
happens to his health. Maybe he has of some type
of addictive personality, and he likes to drink
away all of his money. Or he likes to gamble it
away, and that's actually why he needs loans
to begin with. So there is some risk. There's a risk that
he doesn't pay. But by all indications, he looks
like a pretty safe character. But it's definitely
riskier than this company, because you have no assets to
go after if he doesn't pay. Companies can't randomly get
hit by a bus, a human being can. Companies, for the most part,
cannot become alcoholics, a human can. Who knows? We don't know. But there are
definitely more risks associated with this
individual doctor who does not have assets you can go after. But maybe this is also
not enough reward. You're like, you
know, I heard that I can do even better than
this in the stock market.

So you look at another option. So let's say you
invest in the market. And you're just going
to invest in a bunch of– a broad portfolio,
kind of investing in the market as a whole. The reward here would be
expected return of the market. So you look at historical
results in the market and you say, look it, goes
up and down every year. But over long periods of
time, it looks like people– and this isn't
the exact number– but it looks like people have
averaged approximately 10% per year. So that looks pretty
good, but what's the risk? Well, the risk is that
this expectation is just based on what the historical
returns in the market were.

There are huge periods of
time in the market– I'm talking 10, 20, 30 years
where the market is flat. Where the market
could even go down. In any given year, the market
could go down in the double digits or in the 30 , 40% even,
in a really, really bad year. You really aren't
sure whether you're going to get your 10% per year. So I would say the risk
here is volatility. And volatility just means
it could go up and down. It jumps up and down. It's not going to be a constant
upward trend, like your savings account will be. Volatility. And you have a good chance
that you could actually lose the money that
you're investing. It could go down in any year,
in any month, in any five years, in any 10 years. So once again, it seems
like a kind of risky thing. And you can very
easily lose everything. And let's say that even
10% isn't enough for you.

You say, hey, I want to
look at things that maybe I can get even a better return. So you have your brother-in-law,
who's been out of work for a little bit. So let me write the
brother-in-law right over here. Your brother-in-law has been
out of work for a little bit, and he says that all he needs to
start his new guaranteed money making scheme is $1,000, so
he can buy the equipment, so that he can start
it up in his garage. And the reward– And
there's multiple ways we could set up the reward. We could make it so that
he borrows money for you. We could make it so that you
own part of the business. So let's say the
reward is, you get a 50% stake in the business. And, let's say that your
brother-in-law is right, and this becomes a
million dollar business. So this is a very, very,
very, very high reward, if what your brother-in-law
is telling you is correct.

But what's the risk? Well, the risk here is
obviously that he's not correct and that he squanders
all of your money. So lose everything. And not only could you lose the
monetary money that you put in, it could also ruin
your relationship with your brother-in-law
and maybe your spouse. So, risk relationships. Maybe I should put, you
risk family happiness. Once your brother-in-law
loses all of your money, it won't be so easy at
Thanksgiving anymore to have a civil conversation. So in general, the
overlying– I probably did more of these
scenarios than I needed to– but I think
you see the general trend. The more risk you take in
general, the more of reward you should expect to get. Or the more reward that
you're expecting to get, there's probably
some risk there.

And if there's
something that looks like it's really safe with
the really high reward, one of those two things
are probably not true. So if we were to
plot all of these, and I haven't
really quantified– I haven't given you a
way of measuring risk. In future videos we
can think about that, and academics have thought
about ways of measuring risk. So that's risk and reward,
if you plot it all over here. So the savings account. It's 0 risk. So this is the savings
account over here. It's 0 risk, and
your reward is 1%. So this is 1% right over here. The lending to a
reputable company. It's a little bit higher risk. So this one right over here. It's a little bit higher
risk, and your reward is 6%. So let's say this is
6% right over here. So it's a little
bit higher risk. I'm just saying
risk is increasing. If you lend to the doctor. So let me pick another color
here, that I haven't used. If you lend to the doctor,
once again, the risk is a little bit
higher than lending to that company or
the savings account.

Once again, a little
bit higher reward. Little bit higher reward. You now have an 8% reward. Investing in the stock market. Let me pick a color
I haven't used yet. Investing in the stock
market, Once again, higher risk, but
also a higher reward. Maybe 10 per year. That's 10% right over there. Your brother-in-law,
super high risk, probably off the
charts over here, but also super high reward. So maybe it might be like that. But the general idea is, the
more risk, the more reward..

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