No Guts, No Glory

That's the title of the first chapter in William Bernstein's great book, The Four Pillars of Investing. Here, he begins with establishing the relationship between risk and reward based on a historical review beginning as early as the establishment of the first credit markets more than 5,000 years ago. The relationship between risk and reward, of course, still holds true today. In his chapter summary, Bernstein writes:

1. The history of the stock and bond markets shows that risk and reward are inextricably intertwined. Do not expect high returns without high risk. Do not expect safety without correspondingly low returns. Further, when the political and economic outlook is the brightest, returns are the lowest. And it is when things look the darkest that returns are the highest.

Sounds logical, but a lot of times we don't invest that way. We look for the investment that promises high return without much risk. In fact, Bernstein writes, "the best way to spot investment fraud is the promise of safety and very high returns. If someone offers you this, turn 180 degrees and do not walk--run."

2. The longer a risky asset is held, the less the chance of a loss.

This is one reason why it is recommended that stocks are best viewed as a long term investment. Over time, their return has been above that of bonds (they are riskier, after all), but in the short-term, the risk is even higher than over the long term. I cringe when people ask what stock they should buy with money they don't need for a couple of years (say if they're saving up for a down payment on a home). There's a big risk that even the "safest" stock (even if it's a good long-term investment) could be down over the next couple of years so a money market account, CD, or short-term bond is really the safest bet for such an investment.

3. Be especially wary of data demonstrating the superior long-term performance of U.S. stocks. For most of its history, the U.S. was a very risky place to invest, and its high investment returns reflect that. Now that the U.S. seems to be more of a "sure thing," prices have risen, and future investment returns will necessarily be lower.

Don't forget that 100 years ago the U.S. was considered an emerging market. As our economy continues to mature and become a relatively more stable place to invest, its investment returns should reflect that. Also, as much as we'd like to think that the U.S. economy will continue to lead the world forever, history tells us to expect otherwise. A great place to start with international investing is a broadly diversified foreign fund, like Vanguard's Total International Stock Index Fund (VGTSX). This fund invests in Vanguard's European, Pacific, and Emerging Markets Indexes in rough proportion to their overall contribution to international markets and will change weights over time. A good starting point for many people is to have 20-30% of their stock allocation invested in a diversified international index.