The Spectrum of Risk

Risk & Reward Are The Same

Risk and reward are inextricably linked. Without risk, you cannot expect to gain, and if you desire gains, you must take risks.

Therefore, an investor must plan accordingly to ensure their risk tolerance is suitable; otherwise, when things go awry, they will not be prepared for the next market dip, crash, or recession.

Risk & Investing

When investing, everyone is ecstatic about gains. However, as a diligent investor, you must not invest solely based on the potential upside you desire unless you can handle the associated risks. 

For example, consider the average annualized return of a diversified, aggressive portfolio containing primarily domestic and international stocks and a modest exposure to bonds (60/25/15). Since 1926, such a portfolio has returned nearly 10% annually.

While a return of 10% annually in a diversified portfolio over the past one hundred years sounds splendid, it would have included sweeping performance swings, with losses as much as 61% in some years and gains as much as 136% in others. That is quite the choppy path in the pursuit of gains!

Therefore, new or introductory investors and seasoned market participants must understand that every type of portfolio comes with trade-offs.

While you could tolerate the benefits of your investment strategy, can you tolerate the drawbacks it poses?

During the same time span, a more conservative portfolio, which still contains around 65% equities, 35% bonds, and short-term investments, had an average return of under 6%. However, its gain-to-loss spread potential was much more tolerable for most people, with extremes of +31% and -18% in a given year.

(Historical return data source: https://www.fidelity.com/bin-public/600_Fidelity_Com_English/images/migration/callouts/callouts-B/asset%20allocation%20chart%202025%20update.png)

How Do You Quantify Risk?

Cash has a value that is relatively static and is easy to spend, being worth the same day to day, minus inflation over time. As such, cash is safe and easily portable, but has no long-term gain potential and instead becomes worth less each year. While banks and other institutions will store your money, they generally offer very little in terms of paying interest on your deposited dollars.

Suppose a depositor wants to earn a better interest rate. In that case, they can purchase a certificate of deposit, which will pay a greater interest rate but requires locking up funds for a duration of time. Thus, an individual must accept the risk that they may not be able to access their funds when needed in exchange for the potential to earn more during that period.

If an individual wants to earn a better return than what a bank may offer, they generally look into purchasing US government bonds. Purchasing these investments has a government guarantee that an individual will receive their money back, plus interest. While the US could default on its bond payments, this is unlikely as of now.

If an investor wants a greater return than they can get from the prior three options, they can look at purchasing corporate bonds. Investment-grade bonds typically pay more than government bonds, as companies are more likely to default; however, the risk varies by the issuer's long-term solvency prospects.

After bonds, the next level of the risk and return ladder is large-cap stocks. Examples include behemoths like Alphabet and Johnson & Johnson. Large-cap companies are less likely to fail than smaller companies. Nonetheless, their vulnerability to unforeseen events, such as corporate scandals, the death of a key executive, or unexpected market or regulatory forces, can result in significant valuation losses.

For most investors, venturing beyond large-cap domestic or international stocks increases risks since smaller-sized companies face less scrutiny and can more easily fail.

Finally, investors will encounter startups on the risk scale, which are cash-intensive businesses that often fail. However, investing in a successful one can be extremely profitable.

Investors can trade risk for returns along the outlined risk scale. However, investing in individual stocks and bonds is often not ideal, as beating the market is unlikely and carries a high level of risk, which is why mutual funds and ETFs are often preferable for laypeople, as is commonly preached by advisors and industry figures alike.

The Next Steps

Now that you understand the basic risks posed by different financial instruments, you can begin to consider how to construct a diversified portfolio to meet your individual needs over the short and long-term.

For most individuals, the next step involves choosing to work with a financial advisor, purchasing a few index funds, or a single target date fund, which is the logical next step after they have charted out how much risk they can tolerate to grow their nest egg.

If you are unsure how to quantify your risk tolerance and where you should invest your hard-earned money, we are here to help. At Lundeen Abrams Advisors, we help our diverse client pool navigate risk so they can pursue their financial and life goals with confidence. So, please contact us today to schedule your first meeting with us. We will look forward to helping you soon!