What are the tradeoffs between investment risk and return?

Variety of financial charts show change over time

Finding balance in what you want your money to do for you

Michael Taylor, investment strategy analyst at Wells Fargo Investment Institute
Michael Taylor, CFA
Investment Strategy Analyst
Wells Fargo Investment Institute

One of the most common questions we receive during a run of strong performance in the stock market is: Why isn’t my investment portfolio performing as well as the S&P 500 Index?

Another common question we receive when stock prices are falling sharply—think March 2020 and the COVID-19 market panic as a recent example—is: Should I sell everything and go to cash?

These questions are common because all investors want to feel like they are getting the best returns. Conversely, many are uncomfortable at the thought of losing their hard-earned money even in a short-term market correction.

If you chase returns, you may take on more risk that you anticipate. As the old adage goes, past performance is no guarantee of future results. And if you sell into a falling market, you might be selling at the worst possible time.

So what is the best way to approach the balance between risk and return? We suggest your starting point should be asking yourself:

“What do I want my money to do for me?”

Typical answers are saving for a down payment on a first or second home, kids’ college, or retirement. You may have a more exotic goal, such as planning for an expedition to Antarctica, or a more practical one such as building a business. You may want your investments to provide you with a reliable income.

For any of these goals, you will have either a clear or estimated date in mind for when you need the money:

  • If this date is far off into the future, you may want to take more risk with your investments.
  • If, on the other hand, you will need the money relatively soon, you may want to consider a more conservative mix of investments.

The one thing that you don’t want to have to do is to cross your fingers and hope that you won’t need to draw on your investments during a periodic market correction.

This is where portfolio diversification can help. You may not achieve the best returns of the top-performing asset class, but you also are unlikely to achieve the worst losses of the worst-performing asset class just when you need to draw on your investments. And planning for both risk and return may help you sleep better at night.

To illustrate my point, let me give you a real-life example of a friend of mine. She had diligently saved for her son’s college education in a well-diversified portfolio. She sometimes questioned why she had opted for an age-based approach as the returns were lower than if she had been more aggressive in her investment choices.

Her son’s first college payment was due in the fall of 2015—the year of the infamous “flash crash.” What terrible timing! But this is where diversification and planning worked for her. She was able to make that payment knowing that she wasn’t drawing down funds from a portfolio with large losses that would be hard to make up in the following three years.

It is only human nature to want to see the best returns for your portfolio—even my friend who is a planner by nature questioned her choices. But very few of us have the stomach for risk that enables us to ride out the downs as well as the ups in the financial markets especially if we need the money soon.

Focusing on what the money is for and when you need it can help you think about your investments in a different light.

Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A.

This article has been prepared for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Individuals need to make their own decisions based on their specific investment objectives, financial circumstances and tolerance for risk. Please contact your financial, tax and legal advisors regarding your specific situation and for information on planning for retirement.

All investing involves risk including the possible loss of principal. Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve.

Diversification does not guarantee profit or protect against loss in declining markets. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.