How to Increase Returns While Decreasing Risk in an Uncertain Economy - dummies

How to Increase Returns While Decreasing Risk in an Uncertain Economy

In an uncertain market, the key to managing risk is diversification. By combining different types of investments, you can get the major benefit of diversification: a relatively high rate of growth, with smaller fluctuations in total value from year to year.

The most common measure of investment risk is called standard deviation. Standard deviation measures volatility, or how much annual returns deviate from average returns. High volatility means the security’s value goes drastically up or down from one year to the next. Consider two baseball players: They have the same number of total bases, but one hits singles every time, while the other swings for the fences, striking out a lot, but also hitting more home runs. Same average, different standard deviation.

Standard deviation — and growth potential — differs for different types of securities:

  • Stocks, which produce the highest long-term returns, have higher standard deviations than bonds.

  • Small company stocks are more volatile but grow more than large company stocks.

  • International company stocks, especially those from emerging markets like India and China, have even higher returns and standard deviations.

The neat thing for investors is that the returns produced by these different types of investments don’t move in the same direction at the same time. Their returns aren’t correlated. So when stocks are down, bonds may be up. When U.S. markets are in the doghouse, Asian companies’ stocks may be booming.

Investing in non-correlated securities produces reduced volatility (or risk) and higher returns. Say you have half your money in a U.S. stock fund and the other half in a bond fund. Although the return on the portfolio is simply the average returns of the two funds, the standard deviation, or risk, of the two combined is less than the average of the two funds’ individual standard deviations.