book.chapter Greed blinds investors to risk and return

Investing inherently involves a tradeoff between risk and return. Prior to the 2009 market downturn, many investors lost sight of this key relationship, falsely assuming markets would only continue rising. The harsh reality of losses imposed itself, demonstrating that greater potential returns necessarily entail higher risks - especially during periods of fear like the present. However, for savvy investors aware of the risks, volatile times also present opportunities, provided one knows what they are doing. As investor William Bernstein noted, emotions often undermine sound financial decisions, whereas cool reason preserves capital. The primal urge for excitement leads many to speculation when most returns come from boring allocations across diverse markets. Segregating a small portion of a portfolio for entertainment purposes may satisfy this urge without jeopardizing one's nest egg. But excitement in finance is generally antithetical to prudent growth. At its core, investing serves two logical aims: funding retirement or pursuing outsized gains. These divergent goals demand different strategies. Retirement portfolios favor conservative assets like bonds to preserve capital. Speculative portfolios contain riskier bets with chance of windfall returns. Neither precludes losses, but the risks and outcomes differ substantially. Beyond these structural considerations, human psychology introduces biases hampering objectivity. We crave easily digestible narratives to explain complex market dynamics. Currently, a popular narrative suggests economic calamity leading to worthless stocks – a simplistic distortion ignoring contrary evidence. Well-run companies have always navigated downturns and capitalized on recoveries. Additionally, investing evokes adventure for some, hence enthusiasm for exotic vehicles like IPOs despite their risks. People flee stocks at the first negative headline rather than patiently holding quality assets. Recent trends get improperly extrapolated far into the future, so inevitable reversals shock market participants. Overconfidence in stock picking pervades despite reams of data demonstrating the futility for most. Envy also motivates suboptimal decisions meant to keep pace with others. These emotional pitfalls remain problematic despite our best efforts. But awareness of them allows developing countermeasures. Regularly rebalancing forces selling high and buying low. Stoically embracing market volatility steadies decision-making. Accepting randomness and uncertainty provides inoculation against manias. Perhaps above all, acknowledging the superior expertise of other market participants guards against hubris. In investing, risk and return form two sides of the same coin. Enduring occasional crises allows participating in the highest long-term rewards. Safety from any losses guarantees only the lowest returns. Every portfolio involves tradeoffs between these two poles based on objectives and risk tolerance. For retirement assets, conservative positions preserve capital despite modest yields. Speculative holdings promise exhilarating gains and gut wrenching drawdowns. Most outcomes cluster closer to the middle with reasonable risk-return profiles. Dispassionately assessing one's aims and temperament permits allocating appropriately across the spectrum. No single approach serves all investors. But balancing risk and return remains essential for portfolio performance and investor psychology. Embracing some volatility allows its taming through diversification and rebalancing. The madness of crowds offers opportunities for reasonable contrarians. Ultimately the boring middle way persists as the surest path to investment success for most.