I hear a lot of concern about uncertainty in the market. This is understandable. Our domestic economy remains on thin ice, with dangerously high unemployment and record deficits. The recovery is agonizingly slow.
The situation in Europe is even more dire. The euro is on life support. Greece, Italy, and Spain all have troubled economies. Even China is experiencing an economic slowdown.
The securities industry and the financial media have gone into overdrive in an effort to explain this uncertainty. A typical observation is this one from J.D. Steinhilber in a blog on Seeking Alpha: “I think the environment in 2012 will remain challenging and highly uncertain.” Steinhilber advises investors, “When you don’t really know what lies ahead, but you know there are major potential hazards, it is wise to proceed with caution.” I believe this advice is dead wrong.
It is precisely because of the uncertainty in the market that investors are rewarded. If there were no risk, there would be little reward. Treasury bills are perceived by investors to carry very little risk because they are backed by the full faith and credit of the U.S. Treasury. The latest return on a one year Treasury bill is 0.12 percent. Little risk. Little return.
Higher risk investments (like stocks) have a greater uncertainty of outcome and wider ranges of short-term volatility. The opposite is true for low risk investments. They have narrower ranges of short-term volatility. You can find a chart illustrating the relationship between risk and reward here.
Current prices for stocks and bonds are fair. They are determined by millions of willing buyers and sellers who are fully informed about news and forecasts of future events. Efforts to find mispricings in stocks and bonds are unlikely to be successful.
Based upon the assumption that prices are fair, you can expect a risk-appropriate fair return over time. I am not suggesting that you will always get a fair return on your investments. All we know is that the further the actual future return is from a fair return, the less likely it will be. You can find a helpful chart showing the distribution of monthly returns of simulated investments at various risk levels here. It is the uncertainty of returns that creates the expectation of a future positive return. If there were no uncertainty, there would be little or no return.
The proper way to invest is not to proceed with caution. It is to avoid emotions by being prepared for the random outcome associated with the risk of your investments. Well-educated investors don’t try to predict the impact of future events on their portfolios. Instead, they understand the trade-off between risk and return. They invest in a globally diversified portfolio of low management fee index funds in an asset allocation that matches their risk capacity. Investors shouldn’t fear uncertainty. They should expect it and embrace it as the source of their returns.
Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You'll Ever Read, The Smartest 401(k) Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read, and The Smartest Portfolio You'll Ever Own. His new book, The Smartest Money Book You'll Ever Read, was published on December 27, 2011.
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