Last Updated Aug 7, 2009 10:43 AM EDT
The academic research has found that most of the risk and return of your portfolio is determined by your asset allocation. If you're looking for returns above the risk-free rate (the return on one-month Treasury bills), you must accept risk. But there are two kinds of risk -- systematic and unsystematic.
- Systematic risk -- such as owning stocks -- is risk that can't be diversified away. The market compensates investors for accepting systematic risk with a risk premium (greater expected return) commensurate with the amount of risk accepted. Thus, systematic risk is the good kind of risk.
- Unsystematic risk -- such as owning a single stock -- is risk that can be diversified away. In this case, you're not compensated with a risk premium for accepting this type of risk. Thus, unsystematic risk is the bad kind of risk.
Prudent investors (and there should not be any other kind) recognize that they can't control events. As much as we'd like to believe otherwise, there are no gurus who can tell you with certainty what will happen to the market. Therefore, you should focus on the things you really can control:
- The amount of risk you take. The best way to do that is through index funds (or similar vehicles) that basically own all the stocks in the asset class you want exposure to. Otherwise, you're taking uncompensated risks and ceding control to the "gods of chance." Las Vegas may be a place you may want to go to for a vacation, but it's no place to take your retirement account.
- Costs. The best way to do that is to use low-cost, passively managed funds.
- Taxes. The best way to do that is to invest in passively managed funds, preferably ones that are tax-managed.