Balancing Your Return Ideals With the Realities of Risk

Step 5: How Do I Balance the Risks Against My Expectations?

The foundation of your investment portfolio rests on the investment principles of risk and return:

• Returns are not known in advance. Instead, investors must make their decisions using return expectations, which should be reasonable and mesh with reality.
• All investments are made with the possibility that your actual return won't meet your expectations.
• The uncertainty surrounding the actual outcome of your investment creates risk; the greater the uncertainty, the greater the risk.
• There are many reasons why your expectations may not materialize, and you should be aware of all of them, including: business or industry risk, inflation risk, liquidity risk and market risk. All investments face each of these risks, but to varying degrees.
• There is a trade-off between risk and potential return: the higher the potential returns, the greater the risk, and the lower the potential returns, the lower the risks. Conversely, be wary of claims of high returns with low risk.
• In a portfolio, some risks can be reduced or eliminated with little effect on return through diversification. Always diversify among asset categories (stocks, bonds, cash), within asset categories and among individual securities.
• Diversification is also important across market environments—the longer your holding period, the better. Don't invest in stocks or other volatile investments if you will remain invested for less than five years.
• Do not take on risks for which you will not be compensated. In building your investment portfolio, you are simply seeking answers to these questions:
  • What are the risks?
  • What risks can be eliminated or reduced through diversification and which risks will remain?
  • What are the returns associated with the risks I will be undertaking?

The answer to the last question is a balance of those risks and potential returns, based on your investment profile—your personal circumstances and personal tolerance for risk. Once you have gained your balance and have a steady foundation, you can finish building your portfolio.