Many of us first understand investing through an old adage stating that if you want to pull in life changing returns you’re going to experience a hefty amount of risk. However, the truth is a little more nuanced than that. Investing will always come with risk but we as investors do our part to mitigate it with a well diversified portfolio. Ultimately, “high risk means high reward,” may be one of the most overused phrases in the English language when it comes to investing, and it is incredibly misleading.
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High risk does not mean high reward
Many investors assume that if the stakes are higher, their returns automatically stand to be greater. Unfortunately, this just isn’t how investing works. Risky companies, particularly penny stocks, receive a level of undeserved attention within the financial realm. There is never a shortage of self-proclaimed “successful investors” who made fortunes overnight trading penny stocks. While not all penny stocks are bad companies, penny stocks tend to be so seemingly inexpensive for a reason. No matter how tempting bottom feeding can be, don’t waste your time with bad companies. There is no reason to throw good money after bad.
If a company seems incredibly risky, it may simply not be worth your time, but there are companies out there that make great speculative investments. For example, Virgin Galactic (SPCE 7.76%) is a company that faces two very binary outcomes, either they will succeed with their mission of space travel or they will fail utterly. This makes an investment in the budding company rather speculative. If you are going to invest in an early-stage company, you need to understand the risk you are taking and your allocation strategy should reflect that.
High reward doesn’t mean high risk
On the bright side, at least there are many relatively low risk investments that stand to generate impressive returns. There are a lot of boring, stable businesses that have produced market-thumping results over the long run. Companies such as trash collector Waste Management (WM 0.55%), water utility holding company American Water Works (AWK -0.07%), along with electric utility holding company and wholesale renewable energy provider NextEra Energy (NEE 0.53%) have demolished the market over the past decade. These companies expose their investors to relatively little risk as they provide services essential to the day to day lives of millions of people. Not only are they safer investments, but each of these has a long runway for growth ahead. We are going to need water, waste removal, and electricity for a very long time after all.
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Minimize your risk, buy great companies
Investing comes with a certain degree of risk, but not all risk is equal. Reduce your risk by buying a diverse array of well run companies with the goal of holding them for a very long time. Despite how tempting penny stocks may seem, avoid buying poorly run companies altogether. If you decide that you want to invest in a more speculative company, make sure that you aren’t giving it too much of your portfolio. If a speculative investment works out, owning a small amount goes a long way, but if it doesn’t, you don’t want to own a lot. Finally, don’t make the mistake of overlooking a boring business because it isn’t as flashy. Invest in the companies you believe in and plan to hold them for the long run.
