While the general adage that higher risk equals a higher return is true, you should be aware that you won’t be compensated for taking some risks. A risk that can be diversified away is, by its very definition, uncompensated risk. An example of this is investing in a single stock or even a handful of stocks. Since you can easily buy all of the publicly traded stocks in the world using low-cost index funds, you won’t be paid an additional risk premium for investing in a single stock—even if that stock is Apple.
Explore This IssueACEP Now: Vol 35 – No 10 – October 2016
A novice investor may ask, “What’s a reasonable amount of risk to take in a standard portfolio of low-cost, broadly diversified stock and bond index funds?” Many decades ago Warren Buffett’s mentor, Benjamin Graham, recommended never holding more than 75 percent or less than 25 percent of your portfolio in stocks, with the remainder in bonds. I think that wisdom still holds true today, and you should have a very good reason to go outside that recommendation. If you do decide to leave the relatively safe confines of the publicly traded markets for your investments, limiting risk should be of the utmost importance in evaluating a prospective investment.
Owning stocks, bonds, and real estate isn’t gambling. You’re loaning money to or owning small pieces of real profit-generating enterprises, some of the largest and most successful that the world has ever seen. Make sure the amount of risk you’re taking on isn’t too much, or too little, to reach your goals.