Risk v. Reward
If you desire high long-term returns, you must be willing to accept the high levels of volatility associated with the types of asset classes that produce such returns.
There is a wide spectrum of risk levels among asset classes. Risk is defined as fluctuations in returns from one period to the next.
Lower-risk investments, such as cash alternatives (for example, Treasury bills or certificates of deposit), have averaged modest long-term historical returns. Higher-risk investments, such as large, small, and international stocks, have averaged higher returns historically but with more volatility or fluctuations in value.
One of the first steps in developing an investment plan is to determine which is most important: return stability or long-term investment performance.
Government bonds and Treasury bills are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest, while stocks and corporate bonds are not guaranteed. Certificates of deposit are insured and offer a fixed rate of return. Furthermore, small-company stocks are more volatile than large-company stocks, are subject to significant price fluctuations, business risks, and are thinly traded. International investments involve special risks such as fluctuations in currency, foreign taxation, economic and political risks, liquidity risks, and differences in accounting and financial standards.
It is important to understand that every type of investment vehicle carries risks. Diversifying your portfolio makes you less dependent on the performance of any single asset class.
Effective diversification requires combining assets that behave differently when held during changing economic or market conditions. Moreover, investing in assets that have dissimilar return behavior may insulate your portfolio from major downswings.