When we talk about investment risk, what are we talking about, really?
If you only own a few individual stocks, then bad market declines, a bad economy, or faulty stock selection could lead to a near-total loss of capital invested. The permanent risk of loss is potentially a very great percentage of the money invested.
Owning a handful of individual stocks can lead to overperformance in the short term if you are right (or lucky) on which ones you pick. Still, other investors that have tried this approach have had to overcome loss of capital when the “business risk” of a company caused it to lose a lot of value or go out of business completely.
A properly diversified mix of institutional-quality mutual funds takes that business risk down to a very, very low level. What are the chances that all of the stocks in your combined mutual fund portfolio (probably more than 10,000 individual stocks within a few diversified funds) will go out of business?
So, when we talk about risk in your diversified mutual fund portfolio, what are we really talking about? Market risk is more about uncertainty, unpredictability, and the possible requirement that you hold onto your stock investments that are “underwater” or down in value for what seems like an agonizingly long period time (usually a year or two, but possibly longer).
The price for historic equity market returns seems to be the pain felt when markets are in decline for long periods of time. And to be absolutely clear, there will be significant stock market declines in the future. It is inevitable. We know there will be so-called bear markets, we just never can really know when.
A portfolio of stocks for long-term future growth, bonds for income and stability of principal, and cash for immediately available money is the place to start. This balanced portfolio can help you hold onto your equity/stock positions during the inevitable periods of decline.
The Three Portfolio Approach described in my book The Extreme Retirement Planning Workbook is a practical tool that you can use to begin developing your “sleep-at-night" portfolio.