There is a positive correlation between risk and reward. Higher risks bring higher returns. Lower risks bring low returns.
Each day you hold onto dollars, you become poorer. Over time, inflation destroys the purchasing power of your savings. A dollar today might be worth only $.70 in purchasing power a decade from today.
Understanding investment risk
There is no way to make a risk-free profit. By definition, investments have two sources of returns: inflation and risk. Thus, a risk-free opportunity like a certificate of deposit or US Treasury bill or bond should provide a return equal to the inflation rate. There is no risk to a US Treasury bill or bond, or a FDIC-insured certificate of deposit. In the worst case, you will get your dollars back because the US government will take to the printing presses to make you equal.
Theoretically, there is some risk to the safest investments. If you buy a certificate of deposit and earn 1% per year for 5 years, the risk is that your savings will not grow fast enough to keep up with inflation. Likewise, there is a risk that you won’t be able to save enough for a big purchase or a future retirement lifestyle.
How much risk should you take?
The best time to take a risk is when you’re young, dumb, and invincible. You can easily make up for a loss in your twenties. You cannot make up for losses so easily when you are 70 years old, fragile, and thinking about a life without work.
Risk is measured by how volatile a portfolio is. A portfolio of 100% CD investments will have zero volatility. However, a portfolio of 100% CDs will only reward you with very small, single digit returns. After inflation, you’ll likely lose purchasing power each year.
In the same way, a portfolio of 100% stocks is much riskier as the stock market is volatile. Stocks rise and fall in value by 1% or more from day to day. However, in the long run, a portfolio of 100% stocks provides the highest returns.
Investors should seek to find balance between risk and reward. Here’s a good starting portfolio for a young investor:
60% American stocks – The American stock market is the largest in the world. U.S.-based companies make money domestically by selling goods and services to Americans, but they also have exposure to the international markets. General Motors is an all-American company bought and sold on American exchanges, but it makes cars in Europe, Asia, and South America. One of the best ways to invest in the American stock market is to buy a fund like the Vanguard Total Stock Market Index Fund (VTSMX), which invests in every single investable stock on American exchanges.
20% International stocks – International markets are the riskiest investments as they include up and coming emerging markets with less stable governments and financial markets. However, diversified investors will want some exposure to international opportunities. A fund like the Vanguard FTSE All-World ex-US Index Fund (VFWIX) will put investors right in the mix for international stocks.
20% bonds – Bonds are not the kind of investment that will make you rich, especially since 10-year US Treasury bonds yield less than 2%. Bonds are meant as a safety net to avoid the risk of buying high and selling low. When you rebalance your portfolio, which you should do annually, you’ll sell stocks and buy bonds when stocks rise. When stocks fall, you’ll be selling bonds and buying stocks. Thus, bonds act as a mechanism for avoiding large-scale investment losses. Consider a fund like the Vanguard Intermediate-Term Bond Index (VBIIX), which holds bonds spanning 5-10 years.
Rebalancing and diversification
The example portfolio above would leave you owning more than 5500 stocks and 1400 bonds, despite the fact you’d own only three different funds.
The key to the portfolio is rebalancing your investments once per year, locking in profits in the parts of your portfolio with runaway success and adding to investments that have become relatively cheaper during the year.
Ultimately, though, the goal of an investment plan is to build your net worth. The youngest of investors with student loan debt or high interest consumer debt can replace their bond exposure with faster prepayments on their debt loads. It makes very little sense to borrow with student loans at 6.2% and invest in bonds that yield 1-4% per year. Your debt would make for a better investment.
As 20-somethings build wealth, alternative investments like real estate begin to make sense for more diversification and income. Compared to the easy come, easy go investment opportunities in stocks and bonds, real estate and alternatives make good investments when your portfolio has grown to support more diversification.
As a starter portfolio, a three fund portfolio of American and international stocks and a small position in bonds will give you a great starter portfolio with broad diversification and a balanced risk-profile.
I could not agree more about young investors taking on more risk. I also think that in a time period where you have zero liabilities, it’s an excellent time to learn how to trade in the stock market.
In college, I used to play around with options and learned a lot about trading and made mistakes that I have not made since. Word to the wise, learn while you’re young!
Great article! There is another consideration, though, and that is growing your tolerance for risk through specialization. If you specialize in a certain industry, you’ll get to know the players, and their rhythms, much more intimately than others. When you know just from a new product announcement how that company (and it’s competitors) will fare, you become able to make volatility work for you, rather than against you.
As of right now I am a 80-20 split between stocks and bonds. I may be close to your 60-20-20 you mentioned above since I do have some foreign stocks. Granted this is in my 403b. I think your article is very informative. Although I may still be risk tolerant at an older age, I need to factor in the amount of time left until retirement to lower that tolerance.
Personally, I have a very risky portfolio. I like an aggressive strategy for 20somethings because we have a lot of time to recover from any downturns!
That’s exactly the asset allocation I’m trying to follow because I’m young and believe myself to be nearly unstoppable, haha. Because I’m craving risk, I’m also investing in p2p lending.
“The best time to take a risk is when you’re young, dumb, and invincible.” My step father is 73 and he is taking many more investment risks than I am. Sometimes he hits a homerun. Sometimes he strikes out but he scares me sometimes. Well, I guess you can’t take it with you.
I would suggest considering restructuring the 60-20 on American and international stocks respectively to something that divides by market cap. I say that because most American companies that investors are going to consider will be exposed internationally. I look at each holding or security to see how much exposure they have. Theoretically one could have as much exposure internationally with only domestic stocks, as one could have by only owning international ETFs or mutual funds.
Perhaps investors could consider splitting between small cap, mid cap and large cap.
You suggest that there is plenty of time to make up in the twenties, which would be perfect for the volatility of the typical small cap. Of course, I am viewing all of this through the eyes of ETFs or mutual funds in a 401(k) or IRA.