Let’s say you want to borrow $100 from me, and I have $100 to lend. In exchange for my giving you the $100 today, you promise to return the $100 to me exactly one year from now, plus another $10 for the privilege of using the $100 for the year. We call that extra $10 interest.
Interest is the fee that you pay as “rent” for the use of borrowed money. The cost of borrowing money varies in proportion to the risk that the lender takes on by lending it; that is, the risk that the borrower fails to keep his commitment to return it when it is due with the agreed upon interest payment. If the lender faces a higher risk of default, he will charge a higher rate of interest, or not lend the money at all. In general terms, then, expected returns normally increase with risk.
It would be easy to assume that the relationship between the lender’s risk and his expected return are linear. This is typically not the case, especially when the lender chooses to allocate his lendable assets across a number of borrowers whose risks of default are more or less independent. The mathematical term for this is “uncorrelated.” The more uncorrelated the risks are, the less the risk is for a given level of expected return. If the lender can allocate his loans (“investments”) optimally, then the resulting portfolio is said to be “efficient” or “on the efficient frontier.”
A financial “expert,” at the time the CEO of the company where I was employed, told a large gathering of his employees that we should all put our retirement savings in the company stock. From a risk standpoint, that could have been suicidal. Had the company failed, not only would we lose our income with our jobs, but our life savings as well. Another financial “expert” in this company, today a director, advised me to put all of my savings in the Standard and Poor’s 500 Index fund (also known as the S&P 500). The S&P 500 is a market-capital weighted average of the 500 largest U.S. headquartered companies. This is a considerably safer alternative, but as there are economic factors that affect all of these companies in tandem, it still isn’t “efficient.”
Small companies grow faster than large companies, and companies with large book values relative to their earnings are less “risky” than “growth” companies. The performance of companies based on foreign soil is less correlated with the performance of domestic companies in the same markets; the performance of companies based in developing countries is only loosely correlated with the performance of companies in developed countries. An efficient allocation of investments will have a mix of assets representing assets from each of these asset classes.
Many financial advisors (“wealth managers”) will invest your retirement assets in an “efficient” portfolio for a fee, usually in the range of 1.0 to 1.5% of your assets on an annual basis. Some of them will place your assets in funds with a “sales load,” a commission that comes right off the top, in addition to their fee. An example of these funds is the “American Fund,” which charges a 6.5% sales load. Others place your assets in “managed” funds, where they make the assertion that they can “beat the market” through the application of superior financial acumen. On the average, their performance is, well, average, before they take out their fees. I prefer to invest my investment assets in index funds with minimal fees, offered by Vanguard and Charles Schwab & Co. The index funds, by definition, have the same average performance as the actively managed funds, only without their expenses.
Schwab, in particular, has a free portfolio builder on its customer web site. You enter the amount of money you want to invest, select a level of risk you are willing to accept (your “risk tolerance”), and it allocates your funds among a set of index fund-based ETF’s. It is very simple to use and without the large expenses associated with the “wealth managers.”