Caution in Trading: Be Paranoid, But Be Willing to Take Risks

The most fundamental principle of finance and investing is the relationship between risk and reward. An old gambler's saying is that "scared money doesn't make money," meaning that one must risk losing in order to win. This is true for both blackjack and blue chips - but the appetite for reward must be tempered and mitigated with a thorough knowledge of the risk involved. Follow this guide to understanding this delicate balance. The Concept of Risk vs. Reward Investors define risk as "the chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment. Different versions of risk are usually measured by calculating the standard deviation of the historical returns or average returns of a specific investment. A high standard deviation indicates a high degree of risk." Because there is a very low risk of the federal government going bankrupt, Treasury bonds pay out very low returns. Startup companies backed by "penny stocks," on the other hand, are at a very high risk for insolvency, and therefore have the potential for extraordinary rates of return. Perceived Risk vs. Actual Risk When investing in stocks, a person has a decisive advantage any time he or she can identify a sector in which perceived risk is greater than actual risk. According to one assessment, by investing in stocks or industries that are thought to be riskier than they actually are, an individual can actually make money not from actual risk, but from the risk they are perceived to be taking. As explained by financial expert Peter Briger, "The way that [we] think about the world every day is, we are trying to look at perceived risk and actual risk; and where perceived risk is greatest and we can do our homework and understand the actual risk, that's where we want to invest money." The Four Types of Risk According to Forbes, financial risk can be broken down into four categories.

• Market risk is defined as broadly weighing the political and economic situations in a given country or of the entire world.

• Default risk measures the quality of the underlying investment.

• Inflation risk deals with the fact that money loses purchasing power at about 3 percent a year, meaning that if an investment earns 2 percent a year, you've actually lost a percent to the forces of inflation.

• Finally, mortality risk factors in the fact that all of us are going to die, and long-term investments such as annuities may not payoff totally while we are alive.

Risk vs. reward is the central principle of investing. No investment is risk free, and volumes have been written about walking the fine line between risking too much and risking too little. It is essentially up to the individual to navigate the balance between the two opposing concepts. Be thorough, leave emotion out of it, and always do your homework before writing a check. Did you like this week's Financial Tip Friday? Check out last week's  and be sure to join the discussion on SprinkleBit! Andrew Lisa is a freelance writer living in Los Angeles. He writes about finance and the stock market.