- There are three major types of investments used to build your portfolio: equities, bonds, and alternative investments.
- When you’re choosing a mix of the three, it’s important to understand how they differ on risk and return.
- Finding the right balance of risk and return to suit your goals is an important step in the investing process.
When you’re building a diversified portfolio, you’re trying to find the right mix of different investments to suit your goals.
And while it’s always important to be diversified and have a mix of investments, what makes something the right mix for you?
Typically, it comes down to two big factors that you’ve probably heard of: Risk and return.
Return are the money you expect to earn on your investment.
Risk is the chance that your actual return will differ from your expected return, and by how much. You could also define risk as the amount of volatility involved in a given investment.
Let’s take a look at a quick example:
If you give a friend $100 today, and they tell you they’ll give you $110 in a year, your expected return is $10.
If there’s absolutely no conditions on this, and they’re going to pay you the $110 no matter what, that’s a fairly low risk investment (depending on how much you trust your friend, that is).
However, if your friend is using the money to start a business, and they say they’ll pay you back $120 if their business is profitable, there’s some risk there.
You expect a higher return ($20 instead of $10) but you could end up with nothing if the business fails—which is a big difference between your expected return and your actual return.
That’s risk in a nutshell, and there’s a mix between risk and returns with almost every type of investment.
Understanding the relationship between the two will help you make solid, informed decisions about your investments, and help you understand exactly what’s happening when you check in on your portfolio.
The Four Major Asset Classes
There are four major asset classes that make up most portfolios: equity, bonds, cash, and alternative investments.
While each of those broad categories includes a wide range of investments, typically those are the ones you look at to balance your level of risk with the returns you want to earn.
Equities are any investment that represents an ownership stake in a company, which are commonly referred to as shares.
That might mean holding shares directly, but it could also be ETFs or mutual funds that hold shares in companies.
Typically, equities come with a higher level of risk and a higher expected return. You might earn those returns as capital gains, when the price of the shares you own goes up, or through dividends paid to shareholders when the company is profitable.
However, there’s no guarantee of returns, or a guarantee you’ll get your initial investment back like there can be with bonds, which is what adds risk to equity investments.
Most of the time, bonds carry lower risk and a lower expected return than equities, simply because of how they’re structured.
Bonds are a type of debt, so when you buy a bond, you’re lending the company (or government) money, and you earn a return through interest payments—plus you get your initial investment back at the end of a defined time period.
That’s not to say that there’s zero risk involved in bonds, because bond prices can fluctuate during the time you own them, and bonds can be sold for a gain or a loss before they mature.
Plus, the bond issuer can default on the bond, so that’s another potential risk when you’re investing in bonds.
This is the wildcard category, because it covers everything from investing in real estate, to commodities, to private equity (want to be an angel investor in a startup? That’s a type of private equity).
These investments can be higher risk than both stocks and bonds, but their expected returns follow different patterns than both stocks and bonds, which is what can make them a good diversification tool for an already well-rounded portfolio.
So no, you shouldn’t throw your whole investment portfolio into backing “it’s like Uber, but for camels”, just so we’re clear.
Cash can sometimes mean what it sounds like—holding money in cash in your portfolio—but it can also represent short-term, liquid investments in high-quality securities like US treasury bonds.
They still count as cash, typically because you could access them quickly, and they’re almost as low-risk.
Real World Investment Portfolio Example
Let’s take a look at how this plays out in a real—albeit historical—example.
In this chart you can see the average annual risk and returns for three different investments.
One is equity, one is fixed income (aka bonds), one is cash, and one is an alternative investment in commodities.
|Asset Class||Annualized Return 1994-2017||Risk 1994-2017|
|Cash (FTSE 3 Month T-Bill)||2.49%||.64%|
|Fixed Income (BBgBarc US Agg)||5.31%||3.55%|
|Equity (S&P 500)||9.67%||14.42%|
|Alternative (50% REIT/50% Commodity)||6.58%||17.15%|
You can clearly see that the highest return came from equity, but it also came with the second-highest level of risk.
To reduce your risk a bit, you might have included some of the fixed income category in your portfolio. It would have lowered your returns, but you’d also have diversified your portfolio to reduce your risk over time.
That’s how most portfolios these days will help you find a balance between risk and returns: They’ll find a balance between equities, bonds, and alternative investments that gets you to the level of risk that works for your goals, while trying to maximize the returns you can get for that level of risk.
That’s all a bit theoretical, so here are two quick examples:
If you want to buy a house in three years, you probably don’t want to take a ton of risk with your money—you want your savings there when you’re ready to put your down payment on the house.
In that case, you’d want to optimize a bit more for safety, and a bit less for returns, so your portfolio might skew more towards less-risky bonds and cash, with fewer equity investments.
On the other hand, if you’re saving up for a goal that’s 10 years away, you might be more comfortable with risk right now, since you’ve got a longer time horizon.
To maximize your returns, you might swap around your portfolio to be more equities, fewer bonds, and less cash.
Those are just two simple examples of how different portfolios can balance risk and returns to suit your goals.
You Need to Understand Risk and Return
Just like with any major purchase, you need to understand the risks involved to make sure you’re making a good purchase.
That applies to your house, your education, and yes, your investments.
Now that you’ve got a solid foundation when it comes to risk and return, you can better understand when a portfolio makes sense for your goals, and what will happen to it over time.
Investing 101: Let’s do this
Investing doesn’t have to be something scary and intimidating, and it’s one of the most powerful ways you can hit your goals and build wealth over the long term.
Make a Plan:
- Should I Save or Invest?
- Understanding the Stock Market
- Long-Term Investing
- The Relationship Between Risk and Return
- Investing for Beginners
- The Benefits of Diversifying Your Investments
- Types of Asset Classes
- 5 Common Investing Mistakes