Any person saving money for the future has the tough choice of deciding where to invest money in the meantime. The first principle of finance will help make that decision a little easier by looking at the idea of risk and reward. For example, a 10-year treasury bill may yield 3% while a 10-year Greece bond could yield 10% – looking quickly, an investor may jump to take the Greece bond but there is a reason why the Greece bond yields 10%.
As an investment becomes more risky the yield should also increase due to the added risk. The United States treasury is seen as having little to no risk of defaulting on its bonds, resulting in a lower yield curve. On the contrary the Greece bonds have a much higher risk of a default and its bonds yield a higher amount to account for the added risk. The different yields between the U.S. and Greece bonds are what principle #1 of finance is all about. An investor must be compensated for the added risk of an investment. If you were to graph the relationship between risk and reward they would be positively related, meaning as one increases the other follows.
The most well-known investment choice that reiterates the concept of risk-reward is the New York Stock Exchange (NYSE). Historically the stock market yields on average 10% a year, but every person interested in finance should know the cardinal rule that historical returns do not guarantee future profits. It is a rule worth repeating again, historical returns do not guarantee future profits, this is a rule broken by investors every single day and is a costly lesson to learn. The reason stocks have had such a high yield is because there truly are no guarantees in the stock market.
During the late 1990’s the stock market went crazy over any business that even hinted at entering the new dot.com era. Stocks were soaring through the roof with new interest initial public offerings (IPOS) were making on average 89% after the first day of trading. Average investors became day traders and people thought that it was impossible to lose. After the bubble burst stocks were sent crashing, with the Enron and WorldCom bankruptcy’s being prime examples. Investors were left holding worthless stock and thousands lost most of their retirement savings. The dot.com era is a pure example of how the risk-reward principle works in which investors were paid huge returns but the risk of losing all investment principle was equally as large. Before making any investment decision look at the rate of return and compare it with the amount of risk, because often the high returns really are too good to be true.