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?)
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, 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 July, the Russell 2000 -- home to smaller fries such as Energy Conversion Devices
That's 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: Between 2003 and 2007, folks who participated in the little-fish rally via Royce Pennsylvania Fund (PENNX) enjoyed a whopping gain of 123.8% without experiencing any single calendar-year declines.
For its part, the S&P 500 appreciated by a mere 82.9% over that stretch of time.
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 12 months, investors in a plain-vanilla bond index fund such as Vanguard's Total Bond Index have enjoyed a total return run-up of nearly 6%; the S&P 500-tracking SPDRs ETF
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 a Foolish portfolio
Here's one thing I know: Since we Fools first came around, we have been dedicated to the cause of proving that you can indeed beat the market with individual stocks and mutual funds. What's more, the great "debate" over whether to invest in individual equities or baskets of 'em (i.e., funds) isn't a debate at all: Stocks and funds can -- and to my way of thinking should -- live peacefully (and profitably) in the same portfolio.
Indeed, once you have the ballast of world-class mutual funds in place, you'll be in a much better position to take on the necessarily riskier business of adding individual stocks to your lineup. That's the premise behind the Fool's newest investment service, Ready-Made Millionaire, which features a compact portfolio of just eight holdings: three rock-solid mutual funds, four individual stocks that we believe are poised for substantial outperformance, and an ETF that doubles down on an area of the market that looks considerably undervalued right now. We have skin in the game with our members, too: The Fool has plunked down a million bucks on our lineup.
RMM is reopening to new members next month, and in the meantime, we invite you to learn more about the service and to snag a special free report -- The 11-Minute Millionaire -- along the way. The report features a power trio of tips designed to help you build a less risky, more rewarding portfolio. Click here to access it now.
This is an updated version of an article first published Jan. 31, 2006.
Shannon Zimmerman owns shares of the Royce Pennsylvania Fund. Royce Pennsylvania is a Motley Fool Champion Funds recommendation. Johnson & Johnson is an Income Investor selection. Microsoft is an Inside Value choice. The Motley Fool owns shares of SPDRs. The Fool has a strict disclosure policy.