The game of risk and return is an interesting one.
If you study historical returns and historical risk and the relationship between the two, it is pretty clear that investors get rewarded for taking risk, IN THE LONG RUN, by receiving higher returns on their investments.
The strategy for winning the game of risk and return has two key steps:
– first, you have to have a plan that incorporates your short and long-term goals and how you will invest to meet those goals
– then, you have to follow that plan.
The reward comes from taking risk. The reward is higher investment returns. The risk is varying investment returns – up and down.
Your investment plan has to recognize that there will be ups and downs in the market and that some of those ups and downs may be unnerving and difficult to deal with. But you have to commit to handling them correctly – because this is a precurser to getting the rewards.
When the market falls dramatically, many people decide to pail out. This is one of the biggest mistakes you can make. David G. Booth, Chief Executive Officer of Dimensional Fund Advisors says “You’ve already paid for the risk, so it might be good to stick around for the expected return.”
Because of the risk factor, you do not want to have money that you need in the short term invested in “risky” investments. I recommend that you have two types of money set aside in “cash or cash-equivalent” investments:
1. Emergency funds
2. Any money that you need to use in the next five years. This would include money for college expenses, big vacations, an addition to your house, etc.
The law of risk and return is a law that can pay you big dividends – if you use it correctly.