Risk, return and diversification

Step 1 · Understand risk and return

Expected return is not realized return

Investors take on uncertainty in pursuit of returns. A higher expected return can be demanded from a riskier investment, but higher risk doesn't guarantee a higher realized return. The long-term expected return on stocks is typically higher than on cash, but in exchange their value can vary significantly, and the investor can lose part or all of their capital.

A second, equally important observation goes with this: not all risk is rewarded. If one company makes up most of your portfolio, the portfolio's risk goes up, but the market doesn't automatically promise you a higher return for it. So it's worth taking risk thoughtfully, not taking as much as possible.

Step 2 · Recognize the different risks

Risk capacity and risk tolerance

It's worth telling two things apart. Risk capacity is your financial ability to withstand losses and swings in value. It depends on things like when you need the money, the balance between your income and expenses, your emergency fund, your debts, your other wealth and how flexible your goal is. Risk tolerance is your psychological ability to live with uncertainty without your plan falling apart.

A good investment plan takes both into account. Someone may want to take a lot of risk even though their financial situation doesn't allow it. Someone else could handle large swings financially but knows that a 30% drop would lead to panic selling. Whichever limit you hit first sets your risk level in practice.

To map out your own starting point: Investor DNA test →

Step 3 · Diversify on purpose

The four levels of diversification

Diversification is a way of not taking risk you don't need to take. It doesn't remove market risk, but it reduces concentration risk, especially the kind tied to individual companies, industries and regions. The levels build on top of each other:

Diversification is judged by what you actually own and which risks you're exposed to, not by the number of holdings in your portfolio. And note: a broad global equity index is very well diversified within stocks, but it's still fully exposed to stock market risk. Diversifying across asset classes is the answer to that: Asset classes →

Correlation: why moving out of step is the whole idea

The benefit of diversification comes from the fact that not all investments react to the same things in the same way and with the same strength. This co-movement is described by correlation.

At Level 1, the most important thing isn't calculating a correlation coefficient but understanding the principle: two investments with different names don't necessarily diversify if the same risk lies behind them. Correlations aren't constant either. They can rise exactly when you'd need diversification the most.

Step 4 · Fit it to your own situation

Managing risk is about decisions, not predictions

You don't manage risk by guessing what the market will do next, but through decisions you make before it happens. Your time horizon determines how much volatility you can tolerate in the first place. Your emergency fund decides whether you'll have to sell at the wrong time. Diversification determines how dependent you are on a single outcome. A written plan decides whether you hold on to your investments when the market moves against you.