Taking Smart Risks For Long-Term Returns

More than a few investment plans have gone awry after a sudden loss in the portfolio or a particular stock. Most investors know that physical feeling of sickness when they see thousands of dollars melt away within a few days.

Risk is a part of investing but there are ways to lessen its affect on your portfolio and even ways to nearly eliminate it. You need to understand risk first and how to use it to meet your financial goals.

Risk-Reward and Finding the Right Balance

Risk is fundamental to investing. The market rewards people for saving their money at different levels of risk. Investors that want a guarantee of repayment are rewarded with little through government savings bonds while those willing to take a little more risk, perhaps through bonds of very safe companies, are paid a little more.

The table below shows returns and risk for some of the most common market investments. These returns were calculated using a 25-year time horizon to 2012 and standard indexes as representative of the asset classes. The riskiness of each asset is measured by how volatile it has been on an annual basis, a measure called standard deviation.

Notice that as investors are willing to risk their money with progressively risky investments, they generally see higher returns. You could have made about 7% a year in the SPDR S&P500 stock fund (SPY) over the last ten years. Investors in funds like the iShares Core Total Aggregate US Bond fund (AGG) have earned about 4.2% a year over the last decade. Not nearly as high as stocks but the most the fund lost in any one year was 1.4%, a lot better than the 40% loss on stocks in the year to 2009. If you do not have the willingness or ability to tolerate that much risk, the extreme level of risk might cause you to make some poor investment decisions like panic-selling.

Understanding your ability and willingness to tolerate risk

You absolutely must understand your own tolerance for risk. Neglecting this crucial step and you could face panic selling or not meeting your financial needs. Everyone’s tolerance for risk depends on their own ability and willingness for stock market fluctuations.

Your ability to tolerate risk depends largely on your age, how much money you need now and until retirement, and the size of your current portfolio. Younger investors with a large portfolio and no current need for their investment dollars have the ability to tolerate larger swings in portfolio value on the hope that returns will be higher over the long-term. Conversely, investors with just a few years to retirement and need for current income cannot afford to see their portfolio value drop much. If you already have a nice size nest egg compared to the amount you need in the future, your ability to tolerate risk might also be higher.

Your willingness to tolerate risk depends on your own attitude and nerves. The gamblers and thrill-seekers among us might be able to see their portfolio fall apart without blinking an eye. For those of us with weaker constitutions, just the thought of that kind of volatility makes us queasy. It is perfectly acceptable to want the slow and steady portfolio if you are risk-averse, just as its fine to follow the fast-paced growth stories if that style suits you.

Beta: A technical term for an easy idea

Now that you have an idea of what risk is and how much you can tolerate, it’s a good time to start thinking about stocks and how you can measure risk. The most commonly used measure of risk for an individual stock is called, “beta.” It is the volatility in the stock price compared to the general market.

MGM Resorts (MGM) has a beta of 2.06, which means its stock price is generally twice as volatile as the whole market. Though the shares may move up and down a lot, the idea is that investors will be rewarded for the risk.

Conversely, shares of the Coca-Cola Company (KO) have a beta of just 0.26, which means they are much less volatile than the general market. In fact, when the stock market plummeted more than 50% in the two years to March of 2009, shares of Coca-Cola fell just 20%.

Now, what about diversification?

Not wanting a lot of risk in your investments does not mean you cannot have stocks like MGM. While you will want to limit your overall investment in risky stocks, the concept of diversification means you can have your cake and eat it too.

Because the shares of Coca-Cola and MGM, for example, will not move exactly together then holding both in a portfolio means your overall investment will not be as risky as either stock individually. The exact measure, that of correlation, is too lengthy to cover here but we’ll hit it in another post. Suffice to say, that adding more stocks to your portfolio means that your risk is diminished a little each time. The benefit starts to decrease after around 15 to 20 stocks so no need to buy shares of every stock in the market.

The concept of diversification is really where investors can see the best gains. By doing your homework and putting together a well-rounded portfolio of strong individual companies, you can reduce the risk in your portfolio while still benefiting from the higher return.