Q I don't like taking risks with stocks, but I am looking for good returns on my investments. Any suggestions?
A Risk often is confused with volatility. Volatility refers to the fluctuation in value, while risk, in its most basic form, reflects volatility coupled with a time horizon. Our minds work in very short time periods, so we think of volatile things as risky.
For example, if you are saving to buy a home in two years, stocks probably are too risky because of their high level of volatility. However, over an extended period of time, the level of risk with a stock investment is greatly reduced.
In his book "Asset Allocation," Roger Gibson describes a study that explains this phenomenon quite clearly. For the years 1926 to 1998, stocks outperformed other asset classes in 59 percent of the one-year time periods, 75 percent of the five-year periods, steadily increasing to 100 percent of the 25-year time periods.
This may come as a bit of a surprise. But Gibson concludes that "over a 25-year time horizon, the danger of inflation is greater than the risk of stock market volatility."
So, like it or not, volatility creates returns. In investment jargon, this is considered your risk premium. However, if your time horizon is short, you don't have much time to make up for bad years, so stick with high-interest-paying savings accounts such as ING Direct (currently 3.5 percent), money market accounts or bond mutual funds.
But you might be taking on more risk by avoiding stocks over the long run.
Find a good balance between stocks and bonds, and diversify further between large and small, domestic and foreign. The variety of asset classes will balance out to produce much more steady growth. You'll be more likely to under-perform the common benchmarks in the good years but outperform them in the bad years.
JOE PITZL (24)
Ka-Ching's financial experts at Edina-based Accredited Investors Inc. can be reached at email@example.com.