Here's a basic investing concept that you're probably familiar with but haven't really thought about: the risk-and-reward tradeoff. It's worth examining, though, because misunderstanding it can cost you.
For example, some people swear off the stock market for good after a big dip -- like 2008's nearly-40% drop. Or 1931's 54% plunge in the Dow, which followed big drops in 1929 and 1930. Those declines may have kept your own parents out of the stock market, and if so, check out the kinds of gains they missed in some familiar names over just the past 20 years:
|
Company |
20-Year Avg. Annualized Return |
$10,000 Would Have Become ... |
|---|---|---|
|
Texas Instruments |
14% |
$143,000 |
|
ExxonMobil |
13% |
$117,000 |
|
Nike |
17% |
$230,000 |
|
Johnson & Johnson |
14% |
$137,000 |
|
McDonald's |
12% |
$100,000 |
|
Colgate-Palmolive |
16% |
$188,000 |
|
General Dynamics |
25% |
$818,000 |
Source: Yahoo! Finance.
Lotteries and mattresses
Consider the relationship between risk and reward. The biggest financial reward you can think of is probably a lottery jackpot, offering millions of dollars in exchange for just a dollar. But there's a catch -- it's incredibly unreliable. Your odds of winning are many millions to one. (In fact, you have more than a 99.999% chance of losing!) So, high reward, but high risk.
At the other end of the spectrum are rather "safe" investments, such as savings accounts or even your trusty mattress. If your mattress is fireproof and indestructible, it's pretty low-risk, but it won't keep up with inflation. Low risk, low reward.
Most of us know that much, and we therefore stick to the middle, perhaps with stocks. That's generally smart, but even among stocks there are differences. McDonald's and ExxonMobil are less risky in many ways than a small and more rapidly growing company. But the smaller company carries the chance of a greater reward. Over the long haul, small-cap stocks have outperformed larger companies by two to three percentage points annually.
Weighing your own personal risk can help you balance the need for returns against the desire for safety. Bonds are useful as a brake against bad stock performance. Dividend-payers offer a real edge, especially in down times. And international stocks merit inclusion, too.
So, as you create a portfolio, take on reasonable risk and expect reasonable rewards.
