Which Came First? The Risk or the Return?

Much like the classic dilemma of the Chicken And The Egg, many people are probably experiencing similar confusion about today's markets.

Namely, which comes first?  The Risk or the Return?

First, let me be clear that I believe risk and return are destined to be together forever.  You can't have one without the other.  Or put in more familiar terms, "there ain't no such thing as a free lunch".  There is a ton of empirical data supporting this.

Anytime you hear or see something presented as "low risk, high return" it's time to run quickly in the opposite direction.  Often times, these are financial products that have been packaged and marketed by the old school financial services distribution system.

But the question remains, "Which came first?  The Risk or the Return?"

I believe the answer lies in your mindset and behavioral reactions to the market's inevitable fluctuations.

For example, if the market is currently falling, do you see that as cause for panic?  Do you feel compelled to seek "safety" by moving to cash or CD's?   Do you want to find an alternative to the market until things rebound or your confidence comes back?  Do you feel like you have to do something, even if you're not exactly sure what to do?

Or, do you see a falling market as an opportunity to add investment capital to your currently well-diversified, high quality, low-cost portfolio at lower prices?  Do you think to yourself, "Wow, the markets are on sale, maybe I should load up."

Again, this is purely a matter of perception.  In the case of the former "panic" reaction, I think you would be experiencing a lot of risk with little-to-no-return.  However, in the latter example, based on your perception and understanding of the market, you're actually embracing what others refer to as risk in order to experience greater returns in the future.  These are behavioral issues.

But what's going on when the market is rising and setting new highs?

Is this scenario a thrilling time for you?  Are you seeing all return and no risk?  Are you chasing your "hot" stocks or other investments with additional investment capital?  Are you telling yourself that "this time it's different?"

Or are you using this as an opportunity to rebalance your portfolio back to your target allocation?  Do you have the discipline to focus not just on the return, but to also prudently manage the risk of your overall portfolio by not letting any of your investments stray too far from the long-term plan?

In a rising market environment, you have the choice of focusing on the returns and ignoring the risk, or enjoying the returns while keeping an eye on your risk.

So, regarding risk & return, the question shouldn't be which came first?  The most important question is how can I manage my risks while still participating in the returns?

And the answer lies in a prudent process that removes emotion from investment decisions.

Stay tuned to this website for more commentary on these issues, and also visit The Behavior Gap, which talks about the impact behavior has on investments.

Finally, if you're like most people, you find the current market environment very uncertain, and maybe even a little bit scary.  With that in mind, I encourage you to read "A Manual for Scary Markets".