Key Investment Principle #3…Risk and Return are Related
When it comes to investing, the academics have identified what really matters.
Evidence from practicing investors and academics alike points to an undeniable conclusion when it comes to investing: Returns come from risk. Gains in the marketplace are rarely accomplished without taking risks, but the caveat is that not all risks carry a reliable reward. Fortunately, thanks to the academic community, over the last fifty years financial science has brought us to a powerful understanding of both the risks that are worth taking, and those that are not.
Avoidable risks include holding too few securities, betting on single countries or industries, following market predictions and speculating on "information" from rating services. To all of these, diversification is the antidote. It wipes away the random fortunes of individual stocks and positions your portfolio to capture the returns of the broad market.
Structuring a strategy around compensated and uncompensated risk factors gives purpose to an investor's portfolio. Rather than analyzing individual securities, the more relevant decision becomes one of how much stock to hold versus bonds, and how much small and value tilt those stocks should have. By focusing on these issues, rather than on the noise coming from Wall Street, we focus on the things that really matter in developing a responsible, successful investment strategy.