Most people have strong opinions about risk. Cautious folks steer clear of it. So-called “adrenaline junkies” are drawn to it. Our opinions begin forming during childhood, when we are taught to avoid risk in our everyday lives: look both ways before crossing; don’t run with scissors; wait 30 minutes before swimming after lunch. While avoiding most risks helps keep us safe in everyday life, risk in our financial lives deserves special consideration.
To invest wisely, we must accept that risk and return go hand in hand. This is the most fundamental law of investing. An investment’s potential return is proportionate to its potential loss. Just as there is no limit on how much a stock can appreciate, there is also a chance it could become worthless. In contrast, an FDIC-backed bank certificate of deposit guarantees the safety of your principal, yet offers relatively little in the way of return, thus exposing you to a loss of purchasing power.
Choosing between these types of risks is a compromise between the return we want and the risk (fluctuation in value) we can stand. In other words, risk is the fuel which powers the investment growth engine: how hard you step on the accelerator has implications for how quickly you reach your destination, and the bumpiness of the ride.
Saying “no” to one risk also means saying “yes” to another. Consider the extreme case of an investor averse to fluctuation in the value of her portfolio. She might choose to avoid stocks altogether and invest exclusively in short-term bonds. While this choice will indeed shield her from the dramatic swings in the stock market, the “safer” portfolio will likely have a lower return and fail to keep pace with the rising cost-of-living over time. If she has not saved enough, her choice to reduce one risk has only increased another (perhaps greater) risk—running out of money.
It can be tempting to react to perceived risks—rising interest rates, another recession or the situation in Greece—individually. We never know, however, when each risk will materialize. The first step in managing risk is accepting it will strike without warning. The second is preparing for its inevitable arrival by digging one’s well before one is thirsty. To us, this means constructing a well-diversified portfolio from the outset.
Although the historical record reflects quite favorably on our approach, we realize building an all-season portfolio and sticking with it regardless of the weather may seem too simple. Remember, effectiveness does not require complexity. Consider the humble thermos. It simply and reliably protects its contents much like a diversified portfolio protects its assets from external risks.
Editor’s Note: This article was originally penned by our late colleague, Gordie Gorsuch, whose timeless wisdom lives on in Vista’s investment philosophy.