september 23, 2025 — James Jedlic

How to Leverage Risk and Reward to Benefit you and Ward Off Financial Struggles

In economics, there is a direct relationship between risk and reward, where you have to determine how much risk you’re willing to take based on the possible reward. While greater risk can lead to higher reward, it can also lead to ruin. There are almost zero risk-free ways to make a lot of money. How do you balance the two? Unfortunately, the answer is not quite as simple as the question. While there is a lot of conventional wisdom about risk, it ultimately comes down to your own risk profile. Understanding how much risk you want to take on and the trade-offs is crucial to financial success. The balance of risk vs. reward should inform all your decisions about your money, career, and life.

Knowing exactly what risk is and how it can manifest enables you to make informed decisions, to protect yourself, and to avoid financial stress. Risk in finance boils down to the possibility of losing money. Risk can come in the form of market, credit, liquidity, inflation, and interest rates. Let's go through each one by one. Market, credit, liquidity, inflation, and interest rate risks each affect investments differently. Market risk stems from volatility, credit risk from unpaid debts, liquidity risk from difficulty converting assets to cash, inflation risk from eroding purchasing power, and interest rate risk from rising rates that lower returns or increase debt costs. In short, financial risk is the uncertainty of not knowing how an investment will turn out. Higher risk can mean bigger gains, but also bigger losses. Investors balance the risk they can handle with the rewards they want.

Understanding how you can gain from risk is key to maximizing your reward in relation to your risk. Rewards can come in different forms, including capital gains, interest income, dividends, rental or business income, and appreciation in value, but if you take some risk, there will likely be some reward. In a financial context, it is the way you make money from something. Capital gains are when investments like stocks or houses are sold for more than they were purchased for. Interest income is earnings from money you've lent. Making a family member pay you more than you lent them is considered interest income. Dividends are payments companies make to shareholders from their profits. Dividends combined with capital gains are the two main types of income derived from stocks. Rental or business income is relatively straightforward. It is any income derived from a rental or business. Appreciation is when anything you own goes up in value, like a stock, house, or painting. A reward is the payoff investors seek for taking on risk. Bigger rewards are often tied to higher risks, so finding the right balance is key.

Identifying your risk profile is ultimately up to you, but there are some factors you can look at to guide your decision. The amount of time you have before needing the money plays a big role. Someone who has 20 years before they need to access money can afford more risk than someone who only has 5. In the short term, if you lose money, more time gives you more chances to win it back. Furthermore, you should ask yourself worst-case-scenario questions like: what would happen if my investments dropped 20% overnight? Thinking about the worst-case scenario will limit your reward but protect you from financial stress. However, the simplest way is to start small and build your way up. If you feel uncomfortable about the risk of an investment, give it time until you have more capital, more experience investing, or feel more prepared to assume a greater degree of risk. 

Once you understand your risk profile, you need to choose an investment that fits that profile. Low-risk investments, such as savings accounts and government bonds, are the safest places to keep money, but the tradeoff is that they offer very small returns. Medium-risk options, like index funds and diversified portfolios, provide more opportunity for growth while spreading money across different assets to reduce potential losses, making them a solid choice for steady, long-term investing. High-risk investments, such as individual stocks, startups, and cryptocurrencies, carry the chance of very large rewards, but they also come with the possibility of equally large losses. In addition, time and diversification lower risk, which is crucial in reducing the amount of risk you have to take on to see upside. A longer time horizon reduces risk because short-term ups and downs in the market tend to even out over the years, giving investments a better chance to grow steadily. Diversification, on the other hand, spreads risk across different assets so that if one performs poorly, the others can help balance the loss. Together, time and diversification allow investors to protect themselves from big setbacks while still building wealth over the long run.

Risk and reward are inherently linked in both finance and life. You must find the right balance for you. Without enough risk, you see no upside, but with too much risk, you expose yourself to financial stress. Similar to life, every financial decision you make should be weighed in terms of risk and reward. Since it plays such a large role in your life, taking on risk can feel overwhelming. However, without risk, it is impossible to see reward. That's why it is so important that you find a balance that works for you. Remember, the goal isn’t to eliminate risk, but to balance it carefully so that your choices align with your long-term financial and personal well-being.