We’d all like to avoid the type of investments that cause us to curse! So, one particular four-letter word deserves some attention: risk. Colloquially, risk connotes high stakes—the capacity for great rewards and great losses. In investing, its meaning is more complicated than that.
Not all risk is created equal. There is more than one type of risk–some good, some bad. Good risk is compensated risk: a chance you are rewarded for taking. If someone were to offer you twenty dollars just to walk around the block, there’s a good deal. If they were to offer you twenty dollars to walk through a mine field, no way! The potential harm far outweighs the potential reward.
Now, walking through a mine field might not be a risk you’d be willing to take, no matter what the reward. But rest assured, in investing, some risk is a good thing, as long as it’s the right kind of risk: smart risk. An appropriate amount of smart risk is necessary to grow your assets.
Back to the idea of good risk vs. bad risk. How do you know which risks are worth taking? For instance, stocks are inherently riskier than bonds, but with a higher expected return, a stock is a compensated risk, as part of a balanced, well-diversified portfolio. Diversification decreases the wrong kind of risk, which is why a healthy portfolio is a diversified portfolio!
The bottom line for your bottom line is strategic balance. When making any important decision in your life, you’d carefully weigh the potential rewards against the magnitude of risk to make sure they balance out. Likewise, you want to make sure that your portfolio doesn’t tip the scales too much in any one direction.