Considerations on Risk and Return

November 25, 2016

Risk and return go hand in hand in your investments. Generally speaking, the bigger the risk of an investment, the bigger the potential return.

Golfers and gamblers know well the inverse relationship between risk and return. After a good drive, you may be able to reach that par 5 in two and try for birdie, but that creek in front means that leaving the shot short could put you in range of double bogey or worse. Any craps player will tell you that if you want to win or lose fast, play big money on the hard ways.

These ideas seem natural when talking about such pursuits, but the idea of introducing risk into our investment portfolios seems a little stranger. Investing for your retirement is clearly not golf or gambling, but the concept of risk and how to manage it is very much in play. That’s because risk and return go hand in hand in your investments. Generally speaking, the bigger the risk of an investment, the bigger the potential return.

Every investment brings risk

No investment is entirely without risk, although some investments—like government bonds, certificates of deposit, and money market funds—come close. But the truth is that even those vehicles, many of which are considered savings options as opposed to investment options, bring a different kind of risk: inflationary risk. Because low-risk investments earn only modest returns, inflation can erode the purchasing power of the funds invested. Your investment amount won’t go down, but the value of that investment may.

So, don’t think of your investments in terms of avoiding risks. Instead, think about how to manage that risk and use it to your advantage in your investments. Here are a few ways to do that.

Set—and stick to—your investment goals. We often start at this concept and then work our way around to it again, because it’s that important. Once you’ve established your goals, you can map out a strategy and a timeframe to get you there. This will involve knowing your risk tolerance and your investment window. Work with an advisor or your spouse to create a detailed investment plan. Actually write down your goals, your investment objectives, and your plan for meeting those objectives.

Understand the relationship between risk and time. How many years you have until the finish line for your investment goal should and will dictate how much risk you can take and how much you can bear. If, for example, your investment goal is for your freshman in high school to be able to afford college out of state, you may think you need a big return. But you also won’t be able to lose a big chunk of that investment in a short-term market downturn. If you have a longer time window, you’ll be able to bear short-term market volatility, and your ability to withstand volatility will increase as well. Sometimes, the best investment adjustment is to make no move at all and wait for the market to cycle again.

Diversify and adjust. One of the best ways to mitigate risk is to have balance in your portfolio. This doesn’t just mean investing in growth stocks alongside blue-chip stocks, although that is part of diversification. It may mean investing in completely different kinds of investments, such as a portion in stocks, a portion in bonds, some in mutual funds, and some in real assets such as real estate.

Once you’ve set up your portfolio, the work isn’t finished. As your life changes, your goals and strategies are likely to change as well. The birth of a child, the death of a parent, a divorce, or a career change are just some of the life events that may necessitate a fresh look at your portfolio and may mean a different strategy with a different level of risk.

The key is to understand that as an investor, risk isn’t your enemy. In fact, it can be what drives growth. That doesn’t mean always going for the green on the second shot of a par 5 or betting the hard ways every time. But it does mean accepting risk as part of any investment strategy.