Retirement plan decisions made easy
Drill Down: Risk Reduction: The Free Way
Risk reduction is good. There are two ways to reduce risk, and one of them is absolutely free! That’s pretty cool and seems to violate the “no free lunch” principle. Don’t worry, it is completely true.
Suppose you want to own some stocks. (We could just as easily be talking about bonds or real estate properties, but let’s use stocks as an example.) If you pick a stock at random, I can tell you what the average risk of that stock will be. But suppose that I talk you into dividing your investment between two stocks instead of just owning one. You will reduce your risk by almost half. That’s because some of the time that one stock is going down, the other is going up. The portfolio that is divided between two stocks is far less risky than the portfolio that contains only one.
If I can talk you into investing in three stocks, instead of two, your risk will go down again, but not by as much. At the ultimate limit, you’ve divided your money among all the stocks that are out there. You have reduced your risk, but your expected return is simply the average return of the overall stock market. It’s the return you would expect to have from investing in a single stock but with much less risk.
You don’t even have to go to the extreme of investing in every stock. Just owning 30 or more stocks reduces your risk substantially. The following chart shows how much risk you will have in your portfolio based upon the number of different stocks you own.
If you own just a few stocks, you are taking on more risk than is necessary. Once you get to 30 stocks or more, your risk is pretty low. It can still go lower, but not by too much. (The line looks like it is perfectly flat after a while, but that’s not quite true—almost, but not quite.)
This shows one of the great advantages of mutual funds. They are all well diversified, and almost all have far more stocks than needed to lower risk to a reasonable level. You can even invest in an index fund that literally owns some of every stock out there.
The moral of the story is that for any type of asset, you should be well diversified. If you own stocks, own a lot of different stocks. If you own bonds, own lots of different bonds. (However, bonds start with a lot less risk, so diversification isn’t quite as important.) If you own investment real estate, own many different properties. It is better to own one-tenth of ten different properties than all of one property, at least in terms of your risk.
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Lesson 1: What the Heck is a 401k, and What’s So Great About It?
Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
» Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
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