Risk and return are joined at the head

BOSTON (MarketWatch) � Some people are afraid of making a mistake by taking on risk, while others take risks that lead to mistakes.

Such behaviors are the focus of the new book �Investment Mistakes Even Smart Investors Make � and How to Avoid Them,� by Larry Swedroe of Buckingham Asset Management in St. Louis, who is one of the most thoughtful financial advisers.

No matter your feelings about the market � if you think the current run will continue or you expect a downturn � the mistake comes when you let those feelings override long-term strategy.

That�s what investors need to guard against now. And anyone who avoids the bulk of the book�s 77 different errors is likely to reach the end of their investing lifetime pretty happy with the results.

That said, no blueprint will help an investor avoid all of the potential and theoretical booby-traps. Moreover, even the best investors make mistakes; the key is to avoid the giant ones from which there is no recovery, and to avoid being bled to death by an endless series of small errors.

Timing device

To see how it is impossible to embrace risk while trying to avoid mistakes, you have to look at the real differences between the two.

Click to Play Think you're a smart investor? Check your DNA

WSJ's Jason Zweig stops by Mean Street to discuss new research suggesting that DNA determines one's ability to make smart or risky investment decisions. Photo: Getty Images.

Risk is defined as �exposure to the chance of injury or loss,� while the dictionary definition for a mistake is �an error in action, calculation, opinion, or judgment caused by poor reasoning, carelessness, insufficient knowledge� and the like.

�People who say you�re making a mistake if you put your money at risk � if you do something that exposes you to a potential loss � don�t understand how risk works,� Swedroe said in an interview. �They�re getting out of the market because they see it as too risky, but with interest rates near zero there is a very big chance that they can�t generate the returns they need from riskless investments.

�There�s a risk in everything, so the mistake doesn�t come from taking risks � it�s from taking the wrong risks or taking risks in the wrong amount,� he added.

Investors need to find some moderation in a market that seems to bounce them from end-to-end of the greed/fear spectrum. While the temptation is to jump into stocks when it feels like things are going well and to stay on the sidelines when pain appears imminent, most people lack the skill in timing the market to make that work.

They give it a try, however, because of what they see as past mistakes.

Swedroe noted that a lot of investors look to the recent past and feel, for example, that they made an error being invested in 2008, at a time when the financial crisis buckled the stock market.

�They�re deciding � based on what happened � that they made a mistake being in the market,� Swedroe said, �when there was no way to see just how bad the problems were, and they are trying to avoid making the same mistake again even if that kind of stock market event is likely to happen just once or twice in a lifetime.

�They�re confusing strategy with outcome,,� he added. �They may have taken prudent risks that were appropriate, but then those risks actually showed up.�

Feeling lucky?

In short, it�s like the people who talk with financial advisers and say �I can tolerate risk, I just don�t want to lose any money.� They have no problem with the risks when the investment strategy is working in their favor, but when the outcome is less than expected, they�re convinced they�ve made a mistake.

Most financial advisers, for example, say that the average investor should always have some exposure to the stock market, with long-term money that can ride out the bumps and grinds to capture the long-term trend.

�The mistake most people made in 2008 wasn�t that they were invested in the stock market, it�s that they had, say, 80% of their assets there when they should have had maybe half of their portfolio there,� Swedroe noted. �The mistake wasn�t exposing their money to the market at a time that turned out to be bad, it was exposing too much of their money to the market regardless of the situation, because the losses they suffered � while unusual � obviously were not out of the realm of possibility.�

Confusing strategy and outcome is a way many investors let the ends justify their means.

Sadly, it�s also what leads to the kind of thinking that spurs someone to abandon long-term strategies and go for what looks good today. It�s how someone avoids the chance of losing money in the stock market but assumes the risk that their money won�t keep pace with inflation. The risks are different, but the potential downside is the same � that your money won�t go as far you need.