The stock market, or stock exchange, helps investors invest in a company or companies of their choice. In exchange for purchasing a share of company stock, the investor receives a promise to share in a company’s profits. If the company makes money, the investor can expect to (1) receive some of the profits in the form of a cash dividend, or (2) see an increase in the price of each share—or both. If the company loses money, the investor cannot expect any dividends because there are no profits. The investor will also probably see a decline in the share price.
You may be familiar with Will Roger’s famous quote on buying good stocks: “Don’t gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don’t go up, don’t buy it.” This is a humorous reminder that an investor’s willingness to buy stock depends on the belief that the company will or will not actually generate profits. The bigger the uncertainty, the more return investors want from the stock investment.
Here is an extreme example.
Imagine you have $100 to invest and you must choose between Company “A” and Company “B”. Company “A” sells gasoline. It owns all the gasoline in the world. Company “A” believes next year’s sales will be $1,000 and promises to give you 10% of the profits.
Company “B” sells food for pet sharks. The company believes the Nevada desert is the next big market for sales. Company “B” also promises to give you 10% of the profits from the sales of shark food in the Nevada desert over the next year. They also believe next year’s sales will be $1,000.
Most investors will invest in Company “A” because the expected return is the same as Company “B”, but the risk is much lower. Said another way, Company “B” has too much risk for the amount of return.
A few investors may still be interested in the emerging shark food business in the Nevada desert. But, they know that safer companies, like Company “A”, offer a 10% return. So a few investors approach Company “B” and say, “We like your company but we need more return for us to invest in your shark food business. We want 30% of the profits.” As you can see, high risk investments must promise a higher return potential and lower risk investments will likely produce lower returns.
This is true across all markets—stocks, bonds, real estate—and is a fundamental law of investing: Without risk you cannot earn high return; taking risk, however, does not guarantee a high return.
Bottom Line: Achieving the proper balance between risk and return is an important aspect of a good investment strategy.