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Trading off Risk and Return

In investing, the risk and return trade-off is an interesting one.

When you study historical returns and historical risk and the relationship between the two, it is pretty clear that investors get rewarded for taking risk, IN THE LONG RUN, by receiving higher returns on their investments.

The strategy for successfully making this has two key steps:

– First, you have to have a plan that incorporates your short and long-term goals and how you will invest to meet those goals.

– Then, you have to follow that plan.

Investing reward comes from taking calculated investment risk.

The reward for taking higher risk is higher investment returns. The risk is varying investment returns – up and down.

Your investment plan has to recognize that there will be ups and downs in the market and that some of those ups and downs may be unnerving and difficult to deal with.

But you have to commit to handling those ups and downs correctly – because this is a precursor to getting the rewards.

When the market falls dramatically, many people decide to bail out. This is one of the biggest mistakes you can make. David G. Booth, Chief Executive Officer of Dimensional Fund Advisors says, “You’ve already paid for the risk, so it might be good to stick around for the expected return.”

Because of the risk factor, you do not want to have money that you need in the short term invested in “risky” investments. I suggest that you have two types of money set aside in “cash or cash-equivalent” investments:

1. Emergency funds and

2. Any money that you need to use in the next five years. This might include money for college expenses, big vacations, an addition to your house, etc.

The law of risk and return is a law that can pay you big dividends – if you use it correctly.

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