Risk versus Reward: How to Balance Your Portfolio for Long-Term Success

Investing is all about the future, but having a solid understanding of the history of markets can provide clarity and confidence when dealing with uncertainty. One of the most important concepts in investing is the relationship between risk and reward, which measures how much return you can expect for taking on a certain level of risk.

In general, the higher the risk, the higher the potential reward, but also the higher the chance of losing money. Conversely, the lower the risk, the lower the potential reward, but also the lower the chance of losing money. However, risk and reward are not always proportional, and different asset classes can have different risk-reward profiles over time.

Historical Returns by Asset Class

One way to compare the risk and reward of different asset classes is to look at their historical returns over a long period of time. For example, the following table shows the annualized returns and standard deviations of several asset classes from 1985 to 2019. You can check out the Vanguard Asset Class tool to check out data from 1970 through to 2022 here.

Historical Returns by Asset Class - 35 years (1985-2019)

Data for the graph above on 34 years of returns and volatility for each asset class.

As you can see, stocks have historically delivered the highest returns, but also the highest volatility, among the asset classes. Bonds have offered lower returns, but also lower volatility, than stocks. Cash has provided the lowest returns, but also the lowest volatility, among the asset classes. Gold has been a volatile asset class, with returns that have varied significantly over time. REITs have been a relatively high-returning and high-volatility asset class, reflecting the cyclical nature of the real estate market.

However, these historical averages do not tell the whole story. The returns and risks of each asset class can vary significantly from year to year, depending on the economic and market conditions.

There is no clear pattern or ranking of the asset classes over time. Some years, stocks outperform bonds, cash, gold, and REITs, while other years, the opposite is true. Some years, emerging markets lead the pack, while other years, they lag behind. Some years, gold shines as a safe haven, while other years, it loses its lustre. Some years, REITs boom as property prices soar, while other years, they bust as property prices collapse.

How to Manage Risk and Reward in Your Portfolio

So, how can you use this information to balance your portfolio for long-term success? Here are some tips and strategies to consider:

• Know your risk tolerance and return objectives over a time horizon. Before you invest, you should have a clear idea of how much risk you are willing and able to take, and how much return you need or want to achieve your financial goals based on a time period. Your risk tolerance and return objectives may depend on factors such as your age, income, expenses, savings, time horizon, and personality. You should also review your risk tolerance and return objectives periodically, as they may change over time.

• Diversify across asset classes, sectors, geographies, and styles. One of the most effective ways to reduce your portfolio risk and increase your portfolio reward is to diversify your investments across different asset classes, sectors, geographies, and styles. By doing so, you can reduce the impact of any single asset class, sector, geography, or style on your portfolio performance, and benefit from the different sources of return that each one offers. For example, you can invest in a mix of stocks, bonds, cash, gold, and REITs, as well as in different industries, countries, and market segments, such as value, growth, and quality.

• Adopt a long-term perspective and a disciplined approach. Investing is a marathon, not a sprint. You should focus on the long-term performance of your portfolio, rather than the short-term fluctuations of the market. You should also follow a disciplined approach to investing, such as using a buy-and-hold strategy, a dollar-cost averaging strategy, or a rebalancing strategy, to avoid emotional or impulsive decisions that may hurt your portfolio performance. By doing so, you can take advantage of the power of compounding, which can significantly enhance your portfolio returns over time.

• Seek professional advice. Investing can be complex and challenging, especially in uncertain and volatile times. You may benefit from seeking professional advice from a qualified financial planner, who can help you design and implement a portfolio that suits your risk tolerance and return objectives, as well as provide ongoing guidance and support.

In summary, risk and reward are two sides of the same coin in investing. You cannot have one without the other. However, you can manage your risk and reward by understanding the historical performance of different asset classes, diversifying your portfolio, adopting a long-term perspective and a disciplined approach, and seeking professional advice. By doing so, you can balance your portfolio for long-term success.