How to maximize returns while minimizing investment risk

Back in 2005, someone wrote that would be a good stock in which to invest. At the time, I used Priceline because I traveled frequently. I also knew of Peter Lynch's investing-for-success strategy, which boils down to buying stock in companies you do business with. I looked at the stock, which traded for around $20 to $25 at the time, thought about it … and passed. Was that smart?

Young investor with note that says "return on investment"

Had I invested $1,000 back then, that investment would be worth about $55,000 today, just 10 years later. Priceline is but one of a hundred maximize-return stories you hear every day.

Not every investment is that good. I could also have invested the $1,000 in Yahoo at that time. That investment, however, would only be worth $850 today. The same investment in Bank of America would be worth less than $400 today. We call that risk.

While we've heard horror stories of people losing everything, the truth is that most investments usually have plenty of opportunities to get out before a disaster hits its full extent. However, none of us like the risk of losing even a little, so that's not much consolation.

None of us like to lose anything. On the other hand, don't we all wish we had only one Priceline, Microsoft or Apple in our portfolio? That's the tension all investors, from Warren Buffett to the little girl down the street with her piggy bank, face: return vs. risk or fear vs. greed.

It's All About the Future

The reason most people invest at all is so they can retire at some point in the future. Retirement may look different for each person; but when you boil it down to its basics, it is the point in time from which you derive most of your income from your investments (your capital) instead of from your job (or labor).

The basic problem with all investing is this: Investing is all about the future … and nobody knows what the future will bring. If we knew what the future held, everyone would be a millionaire. Reward and risk both reside in the future, the great unknown.

Two Types of Risk

Even though the future is uncertain, we still have to make decisions and invest something somewhere. Those that did in the past (when they, too, faced the unknown future) are way better off today than those that didn't.

So … investing beats not investing, no matter the uncertainty of the future (or risk).

There are two kinds of risk we face in all our investing:

  • Systemic risk: Systemic risk is the risk that the entire system within which we live will collapse. The most common example of systemic risk is a recession, in which all asset values crash. There is little anybody can do to protect against systemic risk except to wait it out because, in the past, the economy has always recovered.
  • Non-systemic risk: This is the risk that your particular investment will fail, even while other investments keep chugging along. Enron is probably the poster child for non-systemic risk.

Risk vs. Reward

You may have heard people say that, to get a high reward, you need to take high risks. When you consider the Priceline vs. Yahoo example above, you can see it is true. In order to get the home-run investment, you have to pick it at a time when it's impossible to tell a home run from a strike-out, because nobody knows the future.

However, there is a way to capture a good share of the reward without incurring undue non-systemic risk. It is called diversification, and it works like this: Let's say 10 years ago (to pick an easy, random date) you invested $1,000 in each of the following stocks:

  1. Priceline
  2. Yahoo
  3. Bank of America
  4. Berkshire Hathaway (Warren Buffett's company), and
  5. Volkswagen (just to make it interesting).

With hindsight, you know some did well and others did not. As of today, the value of each of those investments was roughly:

  • Priceline: $55,000
  • Yahoo: $850
  • Bank of America: $380 (ouch)
  • Berkshire: $2,300
  • Volkswagen $2,400 (after all the bad news)

Total value for the little $5,000 retirement portfolio would be close to $61,000! Can your smartphone even compute that fantastic return?

But let's say you passed on the Priceline home run and only invested $4,000 in the other four (more pedestrian) stocks. That $4,000 would be worth close to $6,000 today — almost a 50 percent gain over 10 years. That's not too bad when you consider that includes two losers and another unpleasant surprise with Volkswagen.

That's the value of diversification, not putting all your eggs in one basket. The gainers usually compensate for the losers.

There's only one problem with that: There are about 10,000 stocks from which to choose. How on earth do you determine which four or five (or 10 or 20) stocks you should pick for your portfolio? Nobody wants to pick a sure loser simply because the other stocks will carry it. There is no easy and sure-fire way to pick the four (or 20) best stocks. There are a thousand advisers with 2,000 opinions out there, all of them happy to use carefully selected historical data to back themselves up. (I simply used the past 10 years arbitrarily because I have no dog in this hunt.)

So, how do you choose which investments to pick in order to diversify your holdings? Good news: You don't have to. That's because you have another option … index funds.

Index Funds, Simple Diversification

If you've been reading this blog for any time at all you will have seen index funds mentioned a time or two. Why?

The index that most popular index funds invest in is the S&P 500, so named because it contains the 500 most actively traded (and largest) stocks in America. You and I can diversify our portfolios into five, 10, or even 20 stocks … but they buy 500. That's some serious diversification. The Enrons and the Volkswagens get lost in a portfolio that big. (Although, note in passing that even after the recent emissions scandal, Volkswagen was still the best performing stock of the lower four.)

In our example above, we saw how much our little portfolio of four stocks would have grown over the past 10 years. But let's say you decided to invest your $4,000 in an S&P 500 index fund instead. That would be worth about $6,700 today before fees. Let's be conservative and say $6,000 after the fees. Can you see? That's about the same as your little portfolio of four stocks, if not better.

Here's the beauty of index funds: You don't have to spend a hundred hours and 10 sleepless nights anguishing over which stocks to choose for your portfolio. You simply pick the index and you're done. If you spent more than 20 minutes in total you probably overthought it.

Index funds offer you pretty much the return you can expect to get on your own, but with lower risk and, more importantly, no effort.

Granted, your index fund investment wouldn't come close to your portfolio if you happened to include a home-run stock like Priceline in it. But you also don't need to take the risk that the stock you pick turns out to be the next Bank of America (or Twitter).

In Conclusion

There are two ways you can go about laying the financial foundation for your retirement: You can chase maximum returns and accept the risk that perhaps your investment choices might not end up being the home runs you thought they would be … or you can do what thousands do and accept the returns the market in general gives, but sleep easy knowing that you have the safety of massive diversification to protect you from non-systemic risk.

What kind of return are you hoping to achieve with your investments, and how comfortable are you with accepting risk to get there? Does the S&P 500 index fund meet your investment goals?

More about...Investing, Retirement

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