"In investing, what is comfortable is rarely profitable."
- Robert Arnott
Risk & Return
If there would be one principal rule in investing, is that risk equals return. The main idea behind investing is to put your money at risk, and getting rewarded for the risk that you take. The higher the risk you are willing to take, the higher the potential return, but the higher the potential losses.
Imagine risk as being everything that could affect the value the underlying asset of your investment. This encompasses everything from macro-economic trends to political tensions, from changes in consumption to climatological changes, from wars to natural disasters, ... literally everything.
I will illustrate with stocks. When you owe a stock, you literally owe a part of a company. A company is most commonly somehow valued on its ability to make (1) revenue, in order to make (2) profit. In order to make revenue, it must execute business, either selling goods, or providing services. Everything that is of negative influence to this business execution is an imminent threat on the company's performance and hence its perceived value by investors.
Recall that valuation of assets happen by millions of people simultaneously. So when a Samsung brings out a new feature, some of those millions of people will try to sell off their stock of Apple that they possess, fearing that the new feature will have a negative influence on Apple's sales, company performance and thus stock value. Some other of those millions of people might hold on to their stock of Apple because they are convinced that Apple will have an adequate response, or maybe that the feature of Samsung isn't that great after all. So both parts of those millions of people will continuously buy and sell their assets at prices they deem worthy. And it is exactly this behaviour that determines the price of the stock on a continuous basis.
Both buying and selling are a decision, and both can be right or wrong. Selling before an appreciation is a missed opportunity, buying before a depreciation is a straightforward loss, while selling before a depreciation is a won opportunity, buying before an appreciation is straightforward win.
A competitor bringing out a new feature, technological development pushing consumers towards substitute products, poor management having influence on the staff's performance, bad strategic decisions, evolving governmental policies, emission scandals, natural disasters hitting energy plants, currency risk, etc. are only a fraction of possible influences on business performance, and therefore on stocks' prices.
Return encompasses both return as a result of growth in value of the asset, as well as the income generated by recurring payments like dividends (stocks), bond payments, or rental income (real estate).
Return, or the benefits you get from putting your money at work are generally spoken linked to the amount of risk that you are willing to take. This simple truth is a result of the idea that valuation creates demand and offer, and as such steer prices.
Imagine the market being one big room. On one side of the room you have a group of investors around a table discussing the valuation of a stock that is tied to a historical, well-known company, in a very stable industry. Discussions around that table would be rather soft since everyone would more or less agree on the value of the stock price, since "It has always been like this", and nothing changes. It will be very probable that the quarterly results will be as expected, resulting in a stable stock price.
On the other side of that same room there is a group of investors around a table loudly discussing the valuation of a stock tied to a new company, unknown to history, and which is challenging an entire industry. Investors at this table are loudly arguing on whether or not this company will succeed in its purpose, while others are discussing their potential sales,... but basically no one knows exactly how things will turn out.
What will happen investment-wise? On the first table, people know what to get for their money, the risk is low. As soon as some people sell off their assets for whatever reason (they might need the cash), pushing the price down, others will cease the opportunity, replace the leavers, buy the stock and push the price up. Since people know what to get for their money, there is more or less a common agreement on the ideal price to buy.
On the second table, no one knows. Some people will believe the company will succeed, many will not. That first group of people, the believers, will be more prawn of risking part of their wealth on the belief that the company will succeed. If the company fails, they lose a big part of their investment, if the company succeeds and turns around the entire industry, it will most probably have a tremendous first-mover advantage, creating outstanding business results, leading to a significant appreciation of the value of the company. Hence the stock price will rise significantly. There is no common agreement on the stock's price at all, and that stock tend to swing significantly in price.
The power of information
The evaluation of the risk and return by an individual investor depends on his perception and the interpretation of the risk. While one might deem it risky to invest in a particular asset, another might perceive this as entirely safe. A lot of this perception and interpretation depends on the availability of information to the investor. Expertise is probably the most readily form of available information. Someone with expertise about one specific asset or sector, may easily outperform other investors with his assets, because he will be able to more accurately interpret risk compared to other investors. And while other forms of information are readily available, thanks to the internet and mass media, it often lacks time to an investor to interpret all of the available information anyways. In short, investors are limited by their exposure to information.
Insider information, i.e. sensitive information coming from inside the company and known by only a select group of people, is without a doubt the most powerful information to possess in order to invest correctly. However, in all properly regulated countries, insider trading is prohibited and heavily penalised.