The Investment Risk-Return Correlation

by Millionaire Mommy Next Door on August 18, 2010

in Investing,Mailbag

Q: Pam asks, “After my portfolio value dropped by 40%, I panicked and pulled out of the stock market. I have $150,000 sitting in my savings account, earning squat. I know I should put it back to work, but with the state of our economy, I don’t know what to do with it. Any thoughts?”

A: If you’re terrified of the volatile economic climate today and would be an insomniac if you were invested in the market, perhaps it’s best to keep it parked until you are emotionally and behaviorally ready to stomach the ride and stick to a strategy. Preserve your capital while you take some time to reassess your goals and risk tolerance, determine an appropriate (perhaps more conservative) asset allocation, and explore various investment strategies to find a good fit for your goals and personality.

First, let’s address the risk-return correlation. In subsequent posts, I’ll tackle the other pieces.

Generally speaking, the goal of an investor is to be compensated for the amount of risk they take. Better yet, the investor seeks out the best risk-adjusted return — I’ll discuss this piece later.

If you are willing to accept high volatility (investment risk) for a high potential return, consider investing in a diversified portfolio of:

  • aggressive growth funds
  • small cap stocks and funds
  • micro-cap stocks and funds
  • foreign company stocks
  • international funds
  • sector funds
  • precious metal funds
  • emerging market funds

If you are willing to accept moderate volatility (investment risk) for a moderate potential return, consider investing in a diversified portfolio of:

  • large cap stocks and funds
  • S&P 500 and Wilshire 5000 index funds
  • convertible bonds
  • high-yield (junk) bond funds

If you are willing to accept low volatility (investment risk) for a low potential return, consider investing in a diversified portfolio of:

  • high quality short and intermediate term municipal and corporate bonds and bond funds
  • US savings bonds
  • Treasury bills and notes
  • fixed annuities
  • money market mutual funds

If you are willing to accept very low volatility (investment risk) for a very low potential return, consider investing in a diversified portfolio of:

  • CD’s (Certificates of Deposit)
  • money market deposit accounts
  • interest-earning checking accounts
  • savings accounts

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