Investing Basics: These Are the Basics of Risk, Return, and Diversification

The impossible happened, Nav.igator. You looked at your finances, you set a budget, and now you have money left over after paying this month’s bills.

You’re probably thinking: It’s too good to be true! Treat yo’self!

But then you remember that you also vowed to use your extra cash to start investing. And now you’re feeling a little bit sweaty.

How do you decide which investments are the best ones for you? How much risk can (or should) you take? What do you do with your hands?

Let us clarify some of your burning questions and help you get started on creating your own portfolio.

Most people are aware that risk and return go hand-in-hand. When you invest, you are always risking that you won’t get the reward you are expecting.

In the long-term, higher risk should, on average, result in higher returns.

Whether you’re a risk-lover or a risk-hater actually has little to do with what investments you should make. Your age is one of the most important factors in how much risk you can actually withstand.

If you’re young, your risk tolerance (that’s nerd speak for how much risk your portfolio can handle) tends to be high because you have many years of gainful employment remaining, and you have time to ride out market downturns.

If you’re close to retirement, you’ll have a much lower risk tolerance because you’ll need to withdraw from your savings in the next few years and won’t have time to recover from large losses.

Slow down there, risky business. Taking more risk doesn’t always mean getting more return.

For example, you could invest all your money into just one stock like Google. Assume it has an expected return of 10 percent, similar to the overall market expectations.

You’re obviously taking more risk by investing in just one stock than by investing in a market index fund. But you won’t be compensated more for it because it’s an unnecessary diversifiable risk.

Risk is split into two types: non-diversifiable and diversifiable.

Non-diversifiable risk (also called systematic or market risk) is not specific to a stock or industry.

Things that cause non-diversifiable risk include political instability, interest rates, inflation, and recession. This type of risk is unpredictable and impossible to avoid, and therefore is a risk that all investors must accept and are generally compensated for.

Diversifiable risk (also called unsystematic risk) is specific to a company.

Things that cause diversifiable risk are managerial changes, labor problems, or loan default. These risks can be largely eliminated through diversification. Which brings us to…

Diversification is mixing a large variety of investments (like different asset types and industries) within a portfolio to reduce or eliminate the diversifiable risk.

Also known as (CLICHÉ ALERT) not putting all your eggs in one basket.

The benefit of diversification is that the positive performance of some stocks helps to neutralize the negative performance of others, resulting in minimized risk, maximized return, and being one step closer to that worry-free retirement you’re envisioning.

Studies show that it takes about 30 stocks to reach true diversification.

But if you don’t have that much cash to throw around, the rule of thumb is that more stocks are better than fewer.

You can start to see the benefits of diversification even with as few as 10-12 stocks.

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