Increasing Risk May Not Increase Return
Principle #3: While Risk and Return are Related,
Increased Risk May Not Always Lead to Greater Return.
In the market, you cannot expect return if you do not take risk. While risk can and does exist without corresponding return (think: bald tires), return cannot exist without some level of investment risk (think: nothing ventured, nothing gained).
Risk represents potential. Taking risk that is calculated and meaningful affords you access to the potential for incremental return — commensurate with the level of risk you are able to assume. Conversely, assuming excessive and uninformed risk may expose you to unnecessary loss and/or significant tax/cost ramifications.
Understanding and managing risk as it relates to your specific investment policy/strategy can help you greatly in avoiding these common investment mistakes.
Exceedingly conservative portfolio holdings: If your money is not growing, it is shrinking. Over time, the buying power of your money will be eroded by inflation. By taking too little investment risk, you jeopardize your overall earning potential by leaving return ‘on the table.’
Overly aggressive portfolio holdings: If you pursue a single investment or category at the expense of balance (diversification), allocate assets disproportionately (greater high-risk investments than your risk profile can bear) and/or trade too frequently, portfolio returns will likely be eroded by poor performance, unnecessary tax liabilities and needless trading costs. When you assume excessive risk, you may not be paid with a corresponding increment of return.
The cornerstone for successful risk management is an optimal portfolio design — one that reaches the highest level of risk suitable for your unique investment profile and maximizes the return for this given risk level. The key to maintaining long-term control over portfolio risk is to remember that risk is a multi-dimensional phenomenon — one that must be managed holistically and thoughtfully within the context of your long-term investment policy/strategy.