Less Risk, More Reward

A potential investment's "risk/reward profile" is supposed to be a financial media bailiwick, but, alas, all too many commentators use the concept without much in the way of explanation. Certainly, they use it without explanation more often than they use the word "bailiwick." (Which is kind of fun to say, don't you think?)

Calcium deposits
Why so? Well, I'd argue it's because the phrase has, so to speak, become calcified from overuse -- i.e., folks know what it generally means and so they think they know what it specifically means. For instance, one risk/reward truism has it that small-cap stocks are riskier than their bigger brethren but offer the greater potential for reward. Bonds are always a safer (and less rewarding) bet than equities, goes another.

Foolish types, however, realize that when it comes to making prudent investment decisions, in-the-aggregate answers just won't do. Just ask anyone who has missed out on the recent rally in smaller-cap stocks.

Let's get small
For the five years that ended with April, the Russell 2000 -- home to smaller fries such as priceline.com (Nasdaq: PCLN), Hologic (Nasdaq: HOLX), and SAIC (NYSE: SAI) -- has bested the S&P 500 -- dwelling place of such behemoths as General Electric (NYSE: GE), Wal-Mart (NYSE: WMT), and Intel (Nasdaq: INTC) -- by a cumulative 30 percentage points.

Not too shabby on the reward front, but it gets even better when you factor risk (or the relative lack thereof) into the equation. One example: Folks who participated in the little-fish rally via Royce Pennsylvania Fund (PENNX) enjoyed a whopping gain of 130% without experiencing any single calendar-year declines.

For its part, the S&P 500 appreciated by a mere 79% over that stretch of time.

Chestnuts roasting
Moreover, while the old chestnut about bonds is true in a general sense, things get more interesting when you drill down to the particulars. Folks who were invested in just the average emerging-markets bond fund, for instance, were treated to a fat gain in excess of 44% in 1996 -- and a crushing loss of nearly 21% in 1998. What's more, during the last year, investors in a plain-vanilla bond index fund such as Vanguard's Total Bond Index have enjoyed a total return run-up of more than 6.8%; Vanguard 500 Index (FUND: VFINX), meanwhile, has lost more than 5.2%.

The bottom line: When it comes to intelligent investing, don't rely on what you think you know. Instead, rely on what you know.

Beat the market. With mutual funds!
Here's one thing I know: Since we Fools first came around, we've been steadily disproving the old adage that you can't beat the market with individual stocks or mutual funds.

Yet all of this outperformance has come amid much lower levels of volatility than you'd take on with a portfolio of just individual stocks. On that front, one financial truism really is true: Diversification helps keep a lid on stomach-churning performance gyrations.

If that sounds like an appealing risk/reward profile to you, I invite you to join me in our latest and greatest investment service, Ready-Made Millionaire, a real-money portfolio of mutual funds, stocks, and exchange-traded funds that are sure to grow your savings beyond your expectations. To learn more about becoming a charter subscriber, simply enter your email address in the box below.