The most critical component to making sound investing decisions is the risk-to-reward ratio.  This idea is that the higher of risk you take, the higher your expected return should be.  In order to have a successful investment portfolio, you need to ascertain your personal level of risk and how this affects your investments.

Risk-to-reward fundamentals

The risk-to-reward concept applies to any investment. Traditionally, higher risk investments have paid higher returns in order to attract capital. For example, growth stocks should have a higher upside return than does a CD or else no one would risk their money on them.  Anytime you invest, you risk losing your investment due to changes in the market, failure of the underlying investment or other risk factors.  The greater the risk of losing your money, the more profit potential the investment should have.  

Conservative investments are on the low end of the scale, moderately aggressive at the middle, and very aggressive at the high end of the risk scale.  Conservative investments will generally yield lower returns, but have a lower risk of losing your money.  On the other end of the spectrum, a high-risk investment should contain the potential of a significantly profitable return. 

Determining your risk tolerance: time horizon and bankroll 

Each investor has a different level of risk tolerance, which is based both on personal preference and financial circumstances.  In order to more accurately gauge what your tolerance level is, it is important to consider the elements of time horizon and bankroll.

Time horizon refers to the amount of time you will have your money invested.  For example, if you need to have your invested money returned immediately, then a higher-risk stock may not be your best option; if things take a turn for the worse, you could lose a significant amount of money.  On the other hand, if you are looking to invest for a ten year stretch, then you have time to recover from the fluctuations in the market.  Therefore, you can stand to invest in a higher risk stock that would perform well over a longer time span.   

Bankroll refers to the amount of money that you can afford to lose.  While it is a pessimistic way of looking at the market, it is one of the more realistic methods.  As long as you do not invest more money than you can afford to lose, you will not feel as much pressure to sell of investments when the market drops.  The more money you have, the more risk you afford to take, and the less you will personally feel changes in the market. As the saying goes, “It takes money to make money and the more money you have the easier it is to take a chance with it”.

Analyzing the risk-to-reward pyramid

Once you know how much risk you can tolerate, you can utilize a risk-to-reward pyramid to decide where to invest.  High risk investments are at the tip of the pyramid, while more conservative investments make up the base.

The base of the pyramid should be your strongest portion, the part of your investments that support the rest of your portfolio.  These investments should be low risk with certain returns, and make up the greater part of your assets.  This ensures that the majority of your money is protected from any potential losses.  Financial instruments in this section would include savings accounts, money market accounts, treasury bonds, and CDs. 

The middle portion of the pyramid is comprised of medium-risk investments.  These should be stable enough to still allow for a return, but risky enough to yield greater returns.  Investing tools in this category would include real estate, mutual funds, large or small cap equities, and corporate bonds.    

The summit of the pyramid is made up of your high-risk investments.  This should only comprise the money that you can afford to lose, since these investments, such as options or venture capital, may not pan out for a profit.  
Every single investor is different in risk tolerance and financial details.  Some investors have a much greater risk tolerance, while others prefer a more stable portfolio.  You can adjust the pyramid to suit your personal investing tastes, while understanding that your potential reward should be contingent upon your risk.  This requires informed investment decisions, as well as knowing how much risk you can afford to lose.