I’m currently reading the book The Most Important Thing: Uncommon Sense for the Thoughtful Investor by Howard Marks. Inside, he talks a lot about risk. Most people seems to grasp the idea that riskier investments offer the prospect of higher returns. Stocks are expected to offer higher returns than cash or bonds. Bonds are considered less risky, and thus return less. However, Marks states that too many people have a simplistic risk/return relationship in their heads:
Source: Table 5.1, The Most Important Thing
However, there is no requirement that riskier investments will actually provide those higher returns. It’s only the average expected returns that are higher, but since the uncertainty is also higher. Put another way, the distribution of potential returns is wider. To be more precise, he shares this risk/expected return chart instead:
Source: Table 5.2, The Most Important Thing
When I started investing several years ago, I remember reading several personal finance articles that responded to questions from older investors that had some catching up to do with their nest eggs. The solution was simple – own more stocks! You’ll need the extra return, they reasoned. That’s exactly the wrong way to think. There is no easy shortcut to saving more.
By Jonathan Ping | Investing | 10/5/11, 5:15am