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Understanding the Trade Off of Risk and Return

Seth Jentner08/06/2014

We all face tradeoffs in life.  We also face investment tradeoffs that can make a big difference in our standard of living!

Life requires the careful balancing of tradeoffs that arise from competing demands.

For instance, most of us face the tradeoff between working longer hours versus spending more time with our family. No amount of success in business will compensate for failure at home. There is not one right answer. Each of us must understand the tradeoffs and attempt to find the balance that is right for us.

Similar tradeoffs exist with successful investing. A common investment tradeoff is that of risk and return. There is a competing demand between the preservation of your capital and the preservation of your purchasing power. The former may provide for a better night’s sleep during periods of economic uncertainty. However, the latter may help you maintain a comfortable bed in the future after taxes and inflation cause your cost of living to increase.

There is not one right answer. Some investors may consider risk to be volatility. Other investors may define risk as a diminished standard of living.

Unfortunately, individual people rarely have black and white objectives. Many do not understand the tradeoffs they face. And because we are emotional beings, we often allow short-term emotions to confuse our long-term logical plans.

Investors feel the risk of equities in real time. Volatility is immediate and apparent. Conversely, the risk of inflation is not immediate. It takes time to discover that investing in T-bills and other low-volatility investments eventually erodes your purchasing power as you “safely go broke.”

Understanding these tradeoffs and designing the right diversified portfolio for you should help you have a successful investment experience. You owe it to yourself to work with a trusted financial advisor who is not trying to sell you something but will help you design an appropriate mix of investments for you.

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