Retirement plan decisions made easy
Drill Down: Risk Reduction: The Tradeoff Approach
The first step in lowering risk is having diversification for whatever type of asset you own: stocks, bonds, or real estate. The second step is to have different types of investments. So if you currently are all in stocks, you can lower your risk by adding bonds. Or if you own nothing but bonds, you can reduce risk by adding stocks.
The mathematics of investment return is quite different from the mathematics of investment risk. Here are the key results:
- When you blend investments, your return is simply a weighted average of whatever you’ve invested in.
- Example: If you invest half in stocks and half in bonds, your return is halfway between the return on stocks and the return on bonds.
- When you blend investments, your risk depends on the risk of the different asset classes and how those assets correlate with one another.
- Example: When the Packers are playing a football game against the Steelers, you bet with one friend $10 that the Packers will win. With another friend, you bet $10 that the Steelers will win. You have no risk at all. You will lose one bet, but win the other, ending up even. This is true even though each bet, by itself, is fairly risky.
Bill Says: If you combine risky investments in the right way, you can end up with a low-risk portfolio. And it isn’t even magic.
We can see how different blends of investments are likely to work out based upon past results.
First, here’s a quick picture of how stocks, bonds and Treasury bills compare to one another in terms of return and risk. I use Treasury bills as an indication of the risk and return of money market funds, the safest investment choice you have.
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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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