Risk and Return

When deciding upon an asset allocation for your portfolio, what you’re really doing is deciding how much risk you want to take on in order to get to a certain level of expected return. With investing, that’s pretty much all there is, risk and return. You have to take on more risk to get a higher expected return.

There are a few warnings to this concept. The first is that you should not expect higher returns simply by making risky investment decisions. There are extremely risky investments out there with very low expected returns, and there are many investments with the same level of expected return but with very different levels of risk. There are only some kinds of risk, such as the risks involved with broad stock market, that come with a higher expected return. The key point is that if you are going to invest for a higher return, you are going to have to take on some more risk.

The second warning is that risk is generally measured as the degree of potential price changes. Stocks are considered more risky than bonds because the price can change by large amounts, both up and down. However, this definition basically ignores the very real risks that face investments in things like bonds and savings accounts, namely inflation. You need to understand all of the risks involved with each investment when deciding how to allocate your money.

Finally, risk means something different to each person. We all have our own personalities and circumstances that are impossible to capture in a unified definition of risk. Know that here, we are generally talking about degree of price fluctuation as risk, but that definition may only be a part of your personal perception of risk.

Still, understanding the relationship between risk and reward is an extremely important part of building an investment strategy. At the highest level, your stock-bond ratio is an exercise in risk-reward trade-off  If you want to anticipate higher long-term returns, you’ll need to allocate more of your money towards stocks. But if you do that, you need to know that your money will be subject to larger price swings that can have a substantial impact on your long-term savings, both good and bad.

By using a more conservative allocation, i.e. more bonds, you’re lowering your risk of rapid short-term price change, but you’re also lowering you’re expected long-term return. This can be significant when fighting the effects of inflation.

The risk-return trade-off is true with respect to the allocation within stocks and bonds as well. For example, you can decide to allocate more of your stock portion to the small and value segments of the market because the research shows that they should get you a higher return. But it also needs to be understood that this higher expected return comes at the cost of greater risk.

And it’s especially important to keep this relationship in mind whenever someone’s trying to convince you of the benefits of a new investment strategy or product. Friends and professionals alike will tout their approach as one that delivers higher returns at a lower risk than conventional strategies. Almost without fail they will have either underestimated the risk involved or overestimated the expected return. The risk-return phenomenon exists throughout investing. There are no magic bullets.

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