One of the first lessons you learn in a basic finance course is the trade-off between risk and expected return: Investors can increase their expected returns by taking on more risk, and those looking to lower their overall risk profile can generally expect to do so by reducing their expectations for returns.
Many investors with long-term time horizons load up on relatively risky securities, taking on additional short-term volatility with the expectation that this approach will translate into additional long-term returns. In return for stomaching occasional big losses, returns are enhanced over the long run.
Risk premium still exists, even in hectic environments such as the current one. Big ebbs and flows have become commonplace now. If the sinking feeling that you got on Thursday afternoon seemed familiar, that's because it was. It had been less than a month since stocks had an equally bad day.
Days such as yesterday are tough to endure for those with exposure to risky assets, but it might make you feel a bit better to know that you are in fact being rewarded for your heartburn. Don't believe me? Maybe some hard figures will help.
Through Thursday, the PowerShares S&P 500 Low Volatility Portfolio (SPLV) has gained about 5.7% on the year, and the SPDR S&P 500 ETF Trust (SPY) has gained 6.5% so far in 2012. Although SPY investors have experienced bigger drawdowns and lower lows, they're coming out ahead in terms of performance. Of course, you have to pay for that outperformance. And that's exactly what a lot of us did on Thursday; we paid the price for the strong gains tacked on during the previous week.
Slow and steady strategies have tremendous appeal to some investors, but over the longer term, it's often those who take the bigger risks that come out ahead. After Thursday's big selloff, it might seem like the sky is falling, yet large-cap stocks are still up about 6% as we near the midway point of the year. It's been a roller coaster ride to get here, but at least we're on the right side of the line.