To find your maximum return, first focus on risk
— -- Q: What's the best way to turn a small investment into a large amount of cash?
A: There's only one way to boost your return: Take more risk.
It's that simple. If you're not happy with the return of the stock market at large, which Vanguard founder Jack Bogle calls the "market return," you have to take more risk.
What is the market return? It is the return generated by companies from the earnings and revenue they generate selling goods and services. The stock market, measured by large-company stocks, has generated an average annual return of 9.1% since 1928, says IFA.com. And a moderately aggressive portfolio containing large company stocks as well as small stocks and foreign stocks has done a bit better, generating returns of 9.7%, based on Portfolio 75 at IFA.com.
If those returns are satisfactory to you, then your best option is to create a basket of diversified index funds or exchange-traded funds (ETFs). You want to create a portfolio that will catch your share of the market returns, just as you might use a giant net to catch butterflies. You can learn more here about how to craft a diversified portfolio.
To get a bigger return, you'll have to take more risk. You might have to load up on shares of smaller companies or companies in emerging markets, since both generate higher returns and carry higher risk.
Just remember that risk cuts both ways. Small-company and emerging market stocks can suffered vicious corrections that often outdo the correction in the broad stock market.So, by chasing a greater return you may suffer much larger ups and downs in the value of your portfolio. Be sure you're prepared for that
Chasing greater returns might cause you to try to defy the odds and trade in hot stocks, hoping to sell before everyone else does. But many hot stocks wind up collapsing like a circus tent when investors, usually before you, realize there's nothing of substance under the tent.
My advice would be to turn your thinking upside down. Rather than fixating on return, consider your risk tolerance. Clearly, we all want the greatest possible return but very few can endure the necessary risk. Would you plunk down all your money on one spin of the roulette wheel, even though the potential gain is enormous? Probably not, because the large risk of losing it all is too great.
That's why you should measure how much risk you can tolerate before you make a single investment. There are several online risk questionnaires to help you do this, including one from IFA.com and from Vanguard.com.
Once you measure your taste for risk, you can craft a portfolio that will give you the greatest possible return for the risk you're comfortable with. That's a long-term strategy that may not make you rich overnight, but it will give you a fair claim to the market's returns and let you sleep at night.
Matt Krantz is a financial markets reporter at USA TODAY and author of Investing Online for Dummies. He answers a different reader question every weekday in his Ask Matt column at money.usatoday.com. To submit a question, e-mail Matt at mkrantz@usatoday.com. Click here to see previous Ask Matt columns. Follow Matt on Twitter at: twitter.com/mattkrantz