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

{ 17 comments… read them below or add one }

Jan August 19, 2010 at 8:04 pm

Glad to see you posting about investing again !

No gold (metal, not stocks) and long term treasuries?

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Kevin Cimring August 24, 2010 at 6:26 pm

The risk/return tradeoff is one of multiple investment considerations (although probably the main one) that investors should be considering, and is a good place to start. However, this needs to matched with the investor,s goals, age and a number of other factors which will impact asset allocation and overall investment strategy. I look forward to reading the future posts in this series.

Many thanks
Kevin.

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John October 29, 2010 at 5:12 pm

Why don’t you have whole life insurance from a mutual carrier as an asset class?

A WL policy with high cash value and a low death benefit gets tax-free returns of 3-6%/year – no matter what the stock or real estate markets do.

Reply

WayToWealth Guy March 15, 2011 at 5:23 am

Thanks for the post. How much equity do you think a person should hold in his/her 50s/60s/70s?

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Jason March 31, 2011 at 12:10 am

If you have a low risk tolerance level but want to have your money work for you, invest in some growth & income mutual funds.

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Darren July 12, 2011 at 12:37 pm

I read this book called Work Less, Live More by Bob Clyatt. In it, he talks about a rational investing portfolio.

By investing in various asset classes (some of which Jen mentioned above) at specific percentages, people have achieved 8-10% returns in the past with low volatility.

I’ve started following this philosophy. If I was Pam and had $150,000 uninvested, I’d look into this portfolio as well.

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DanielJack August 1, 2011 at 2:36 am

This needs to matched with the investor,s goals, age and a number of other factors which will impact asset allocation and overall investment strategy.
Generally speaking, the goal of an investor is to be compensated for the amount of risk they take

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Jeanette @ yesiamcheap August 29, 2011 at 6:36 pm

I believe that only those who will risk going too far can be the one who possibly find out how far they can reach. Being a risk-taker is just one of the qualities of a successful businessman. But I also agree that to give you a peace of mind about your investments better to reassess things, there’s nothing wrong with it.

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Brad August 30, 2011 at 12:30 am

With inflation and austerity measures looming, what reasonable alternatives are there to equities right now. Agree with Jason, if you have a low risk tolerance level invest in growth and income mutual funds…but at least give yourself a shot at getting your nest egg to a reasonable size for retirement. 2-3% on 150k (treading water at best) is not going to get it done.

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Money October 25, 2011 at 3:13 am

Pan as economy does not seem favorable to you, you should go with low volatile investment. It would certainly give you low income but until you feel confident you should stick to this concept. And diverse portfolio is helpful in all situations.

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Tom@easyfinance May 14, 2012 at 5:42 am

I completely agree with your point. I would stick to the stand point that until and unless you become confident and stable enough to take up a challenge, you should go for the low volatile investment. At the very 1st phase you may earn lower than usual, but with time you would be able to handle the situation with ease.

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MyMoneyDesign.com November 11, 2011 at 4:54 pm

Go with a 50/50 stocks and bonds portfolio. History has shown over time this arrangement has less risk than an all stock portfolio while only having a marginally lower return rate; basically an optimal risk / reward trade-off. The wrong answer is to let it sit and do nothing.

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joel fernandes December 7, 2011 at 7:47 am

its a shame that our banking system doesn’t give us more i nterms o fhigher APY on certificate deposit schemes,those are the least trouble and low risk.the irony of the whole thing is that higher paying investment methods often involve higher risks and need constant attention.

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Iroko@Creating Millionaires December 21, 2011 at 5:38 pm

The idea is to be able to identify investment opportunity from afar and know when to enter any market and the right time to leave…from the question why not ty other market, it all about financial education!

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David @ yesiamcheap January 1, 2012 at 12:51 am

For me, low volatility is the way to go. I’m not a gambler! Savings bongs are always a safe bet.

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megan May 5, 2012 at 9:45 pm

What happened to Millionaire Mommy Next Door?
I used to love reading your blog, I hope everything is ok.

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Jason Channing June 2, 2012 at 6:02 pm

Well the stock market today is based on playing on rallys. Basically, get in when the stock start to run. Sell on the way up.

Since, it’s a bear market. You can try to get some shorts and swing trade those. I’m just saying. Don’t play one direction. You can always play the down direction the red direction which is shorts. Always have a stop loss. That is your insurance in stocks. Always always have stop loss. Have a play. When your going to take profits and when your going to leave when you lose.

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