The truth about risk

No doubt you've heard there's no reward without risk. That's as true of investing as it is of anything else in life.

Historically, each of the three major investment asset classes—stocks, bonds, and cash—has produced pretty consistent long-term returns, along with pretty consistent degrees of risk. Understanding these historical patterns can help you handle risk in your own portfolio.

Research we've done at Vanguard has shown that getting your asset mix right can have more impact on your long-term returns than anything else—it's even more important than the individual investments you choose.

How to strike a balance

For investors, risk comes in many forms. There's the risk of a downturn in stock prices. There's the risk that inflation will erode an asset's purchasing power. There's the risk of political instability affecting international markets. And so on.

Achieving long-term financial goals means accepting the trade-off between risk and reward, and understanding the historical patterns that have gone along with the three primary asset classes. Stocks, historically, have offered higher long-term returns than bonds or cash, but they've also carried more risk. Bonds have offered higher returns, with more risk, than cash. Cash has provided a measure of stability, but money that's stuffed in your mattress nets zero return and will probably fail to keep pace with inflation. Paradoxically, taking a conservative approach to market risk may expose you to a high degree of purchasing power risk.

Fundamentally, how you allocate your assets among stocks, bonds, and cash depends on how much risk you're willing to take for an expected return. And that depends on why you're investing, and when you need your money.

So, what's the right way to divvy up your portfolio? You'll need to answer three basic questions:

1. What are your goals and time frame?

To manage risk effectively, first establish your goals. (Are you saving for retirement or a vacation? Or both?) Next, set a reasonable time period to reach them. Generally, the longer your time frame, the more money you can consider allocating to stocks and stock funds, which have had the greatest long-term potential for growth.

For near-term goals—those less than a year away—think about conservative cash investments, such as a money market fund. On the other hand, if you're saving for something a little farther out, such as a down payment on a house with a time frame of three years, give some thought to lower-risk assets like short-term bonds. If you're looking even further down the road to retirement, you may be able to afford to invest more aggressively in stocks—as long as you're willing to accept the added risk.

2. How well do you sleep at night?

Over the last 80 years, as you can see in the interactive illustration above, stocks have turned in the strongest overall long-term performance of all three asset classes—with some painful short-term setbacks along the way. To be a successful investor, you need to expect the unexpected and be prepared for bad days as well as good ones.

As the chart below shows, annual returns for stocks have fluctuated much more dramatically than for bonds and cash, ranging as high as +54% and as low as –43%. It's easy to handle the upside of stocks, but some investors would have trouble sleeping after a steep drop. While bonds haven't offered the same high reward potential as stocks overall, they generally haven't fallen as far either. That's why having a mix of stocks and bonds in your portfolio sometimes can lessen the severity of turbulence nightmares.

Highs and lows
Range of returns for each asset class, rolling periods, 1926-2008

3. Are all your eggs in one basket?

You can further reduce your investment risk through diversification. That means spreading your assets around—across different asset classes, market sectors, capitalization levels, and countries.

An easy way to do this is by investing in mutual funds, which can provide exposure to hundreds of securities in one investment vehicle. You could build a fully diversified portfolio—one that encompasses multiple asset classes as well as a broad spectrum of securities within each class—by owning just one broadly diversified index fund. You can also invest in funds that focus on different market sectors, industries, countries, or market capitalizations (that is, sizes of the companies they're invested in).

Just bear in mind that no amount of diversification can guarantee you'll turn a profit or protect you from losses in a declining market.

For a look at how different combinations of the major asset classes have fared over the last 80 years, view our model portfolio allocations. For help coming up with your own asset allocation, take our Investor Questionnaire.

Stay focused—and balanced

Once you've implemented an asset mix you're comfortable with, day-to-day movements on Wall Street can change your portfolio without your even noticing it, even if you never make another transaction.

In a long bull market, the relative value of your stock funds might grow to dwarf your holdings in bonds and cash. As a result, you'd be taking significantly more risk than you'd originally intended. That's why it's wise to periodically rebalance your portfolio to keep it from drifting too far from your asset allocation targets.