There's an old investment adage that money managers toss around – "be risk diverse, not risk averse". But what does this intriguing concept really mean and why it is so important?

Risk is Good?
Risk is at the core of investment and is essential. You really cannot make any money without taking some risk, but excessive or irrational risks can be disastrous. Accordingly, there is nothing wrong being either risk friendly or risk averse. But there is something wrong with undiversified or mismanaged risk, or a portfolio that is so risk-free that it is also return-free.

Prudent Risk-Friendliness
The slogan above is making a very specific point and one that is extremely important. Namely, if you are both willing and able to take more than an average level of risk, you must do so sensibly. Higher risk does not mean putting all your eggs in one basket or gambling. A good higher-risk portfolio will invariably still comprise various asset classes and be managed actively and sensibly.

Consequently, at least to some extent, you can be more risk friendly than you thought, provided it is really done correctly. Prudent risk-friendliness does make sense. In other words, you should not shy away from risk per se, but away from too much or the wrong kind of risk.

Risk Tolerance
Certainly, you need a level of risk that you feel comfortable with in terms of your own personal risk tolerance. Yet, by the same token, you should feel perfectly comfortable with a sensibly diversified and well-managed medium or even high-risk portfolio, rather than leaving your money in the bank rotting away for years. (For more, see What Is Your Risk Tolerance?)There have even been cases of beneficiaries suing their trustees for leaving hundreds of thousands of dollars purely in cash or bonds for thirty years. If you compare the results of a well-diversified portfolio, it is shocking how poorly a truly low or no-risk portfolio performs.

At the same time, trustees also get sued for portfolios that are almost totally in equities. Many naïve investors thought their trustees or brokers were just wonderful until 2000, after which all-equity portfolios came crashing down and the brokers were standing there like the emperor with no clothes. (To learn more, see Market Crashes: The Dotcom Crash.)

In short, you do not want either of these extremes. You need something in the middle, or possibly a bit more risky than that, but only if it is well managed.

What Does That Look Like?
I recommend that you have at least three asset classes and probably more. Equities, bonds and, say, real estate (plus cash) should be the minimum. And you can certainly extend this to private equity, foreign funds, hedge funds and so on, depending on the markets, your preferences and objectives.

You should not be trying to "time the market" precisely, but do keep an eye on all your asset classes - those you have now and those you may want in future. Furthermore, you will want to ditch some and/or reduce your existing holdings from time to time. Over time, buying and selling is essential in order to optimize your portfolio. (Learn more in, Rebalance Your Portfolio To Stay On Track.)

It is also important to set at least some limits, such as on exposure to U.S. equities, or to particular strategies. For instance, you may want to have some value-based funds and some that are simple trackers. Similarly, some stop-loss procedures are often indispensible, particularly with higher risk assets, so as to avoid disastrous plunges in value.

You also need to know how your different strategies interact with each other and understand how good and bad investments mutate and evolve over time. The essence of the matter is to start with a sensibly diversified portfolio and to keep it sensibly diversified over time.

Isn't This Rather Complicated?
It can be, but need not be. If you work with a good advisor or even on your own, you can keep it simple and still do well. You do not need excessive numbers of assets to diversify and active management does not have to be all that frequent.

A really active stock-picking process with masses of buying and selling can be a full-time job, and given the benefits, is often a fool-time job. For most investors, you and/or your broker just need to meet every few months (possibly monthly), or ad hoc if something changes suddenly. You can take a look at what you have, how it is doing and whether there are any danger signs with your current assets, or anything promising out there that you do not yet have. This is not a big deal and neither terribly stressful nor time-consuming. (For more, check out Evaluating Your Stock Broker.)

But if you just leave your money stagnating in the bank or drifting up or down like a ship in the ocean, you are unlikely to do well. Furthermore, you won't reap the potential benefits of taking the right risks at the right time.

The Bottom Line
Tempting as it may be for cynics or those who really cannot be bothered with their money, just avoiding risk is not clever and not the answer. It is impossible to earn a decent rate of return over time on a portfolio that is too conservative. It will avoid losses in crashes, but also avoid profits in the good times. And there are always good times and bad times for each type of asset class.

The real trick is to take the right risks in the right quantities at the right times. No one can get all of this spot on, but you do not need to do so in order to optimise your portfolio. You just need to have a sensible level of diversification, even at relatively high levels of risk, and be willing and able to both monitor the portfolio and take action when necessary. (For more tips, see Risk And Diversification: Diversifying Your Portfolio.)

Related Articles
  1. Mutual Funds & ETFs

    Top 3 PIMCO Funds for Retirement Diversification in 2016

    Explore analyses of the top three PIMCO funds for 2016 and learn how these funds can be used to create a diversified retirement portfolio.
  2. Investing Basics

    How To Invest In Penny Stocks

    Penny stocks are highly speculative and very risky for many reasons, including their lack of liquidity and small market capitalization.
  3. Mutual Funds & ETFs

    The 4 Best Lord Abbett Mutual Funds

    Discover the four best mutual funds administered and managed by Lord, Abbett & Co., LLC that offer investors a wide variety of investment strategies.
  4. Mutual Funds & ETFs

    The ABCs of Mutual Fund Classes

    There are three main mutual fund classes, and each charges fees in a different way.
  5. Investing Basics

    10 Habits Of Successful Real Estate Investors

    Enjoying long-term success in real estate investing requires certain habits. Here are 10 that effective real estate investors share.
  6. Investing Basics

    5 Types of REITs And How To Invest In Them

    Real estate investment trusts are historically one of the best-performing asset classes around. There are many types of REITs available.
  7. Investing Basics

    5 Simple Ways To Invest In Real Estate

    There are many ways to invest in real estate. Here are five of the most popular.
  8. Investing Basics

    5 Common Mistakes Young Investors Make

    Missteps are common whenever you’re learning something new. But in investing, missteps can have serious financial consequences.
  9. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  10. Mutual Funds & ETFs

    The 4 Best American Funds for Growth Investors in 2016

    Discover four excellent growth funds from American Funds, one of the country's premier mutual fund families with a history of consistent returns.
  1. Where did market segmentation theory come from?

    The first official proposal of market segmentation theory (MST) appeared in J.M. Culbertson's "The Term Structure of Interest ... Read Full Answer >>
  2. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  3. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  4. What's the difference between a stop and a limit order?

    Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you ... Read Full Answer >>
  5. Are secured personal loans better than unsecured loans?

    Secured loans are better for the borrower than unsecured loans because the loan terms are more agreeable. Often, the interest ... Read Full Answer >>
  6. Which mutual funds made money in 2008?

    Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center