A Four-letter Word That’s Not A Curse (part 2)

An efficient, well-diversified portfolio features a balance of different asset classes. From that balance point, you can adjust the proportion of your assets you have in various classes to take on more or less smart risk, depending on your investment goals. Smart risk is the good type of risk, the kind that boosts return. But always keep in mind that no rational investor takes a risk that they can’t expect to be compensated for.

For a lot of people, when we think of high-stakes investing we don’t exactly think of playing it safe. Our pop-culture perceptions are often misconceptions: we hear about the big-name IPO that creates overnight millionaires, and start daydreaming about betting it all on the right stock and cruising into early retirement. Don’t quit your day job! While such circumstances can occur, they are very exceptional.

Worst of all is the myth of the so-called magic formula, marketed by a supposed whiz who claims to be able to outsmart the markets. If you want long-term success in investing, you’ll fare far better by making a rational plan and carefully sticking to it, than by gambling your savings on hand-picked stocks.

Here’s why: speculating on a single stock is the wrong kind of risk. Remember that asset classes with higher risk overall come with higher compensation in the form of greater expected returns. On the other hand, the market doesn’t naturally compensate investors for picking and choosing among single stocks, because the risk you’re taking on in that case is the risk of the individual company itself. It’s concentrated risk—and that version of this four-letter word could leave you cursing in the end.

You can avoid taking on the bad type of risk by owning an index fund, which basically incorporates all the stocks in an entire asset class. Some stocks in that basket will do better, and some will do worse, which diffuses the risk. But there’s just no way to handpick stocks and guarantee that you will be compensated for the risk.

Betting on companies one by one is more a form of speculation than investing—and over time, those “magic” formulas are no match for market forces. Keep your investing strategy in the realm of the rational and real when it comes to taking on risk.