One of the challenges facing all investors is obtaining a balance between risk and reward.
In other words, seeking higher rewards inevitably means that the risk of loss increases. For example, playing the lottery can be a highly rewarding pursuit for the few. However, for the many it can lead to losses.
By contrast, gold has historically been seen as a low-risk asset that is a store of wealth during challenging economic periods. However, with a lack of income and less favourable growth prospects during economic ‘booms’, it may be unable to provide sufficiently high returns in the long run.
Therefore, buying FTSE 100 stocks could prove to be a sound ‘halfway house’ between the two. It offers a high income return, the potential for capital growth, as well as diversification opportunities to reduce the risk of loss.
The FTSE 100’s return prospects seem to have been overlooked by many investors of late. This could be because the index has experienced a rather disappointing 20-year period. During this time it has risen by less than 10%, with its performance in the aftermath of the tech bubble having been somewhat lacklustre.
However, the fact remains that the FTSE 100 offers investors access to the world economy. Since it is due to grow at a fast pace over the long run as emerging economies such as China and India continue to post annualised mid-single-digit GDP growth, the prospects for the index’s members could be bright.
Furthermore, with the FTSE 100 having been grossly overvalued at the end of the 20th Century, it could be argued that a period of lacklustre returns was inevitable. Now, with a relatively high yield and members that trade on wide margins of safety, the index could be set for a period of growth over the coming years. This could be boosted by its income returns, since a relatively large proportion of the index’s constituents currently have yields that are above 5%.
As mentioned, there is a risk of capital loss when investing in the FTSE 100. Any stock can experience a challenging financial period, while the index itself experiences periodic corrections and bear markets that can lead to severe losses for any investor.
However, the FTSE 100’s risks can be mitigated to some degree by diversification. This can reduce company-specific risk, which is the potential for a single stock to drag down the performance of a portfolio. In the long run, a diverse portfolio may produce smoother and less volatile returns than a portfolio which is relatively concentrated.
A balanced approach
Therefore, from a risk/reward perspective the FTSE 100 appears to be appealing. It may not offer the scope to become an overnight millionaire, as is the case with the National Lottery, while its defensive credentials are lower than those of gold. But, in the long run, it may provide a favourable outlook for most investors that leads to financial freedom in older age.
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Peter Stephens has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.