In my experience of guiding investors, I find that it is common for them to underestimate the risk of their investment portfolio that they bring in. How are investment portfolios measured in regard to risk? What is risk as it relates to investments?
Risk is defined as uncertainty. It is the uncertainty that the performance of the investments will be what the average historical return has been. We all know that our investment portfolio does not receive the average historical return every year. The average historical return is calculated based upon all of the previous returns, both above the average and below the average.
Let’s give an example of two investment portfolios that have the same average return, but different levels of risk:
Investment portfolio 1 has the following rates of return the last three years:
10%, -10%, 3%. The average return over the three year time period is 1% (10% + -10% + 3% divided by 3)
Investment portfolio 2 has the following rates of return the last three years:
0%, 2%, 1%. The average return over the three-year time period is also 1% (0% + -2% + 1% divided by 3)
Investment portfolio 1 has more risk, because each year’s returns vary more dramatically from the average than investment portfolio number 2. There is more uncertainty or volatility. Each year’s returns are much farther from the average.
This distance from the average can actually be numerically measured. In investment jargon, risk is measured by “standard deviation”. The higher the standard deviation of an investment, the more the risk. The higher the standard deviation of investment, the more uncertainty the returns are each year (both positively and negatively).
What is the goal of a portfolio? And optimized investment portfolio will have a standard deviation that is equal to or lower than the average return. An investment portfolio with a 5% average return and a 5% standard deviation (or lower) would be ideal.
Unfortunately, what I generally see when testing an investment portfolio is a standard deviation that is up to 2X the average return.
For example, if an investment portfolio had an average return to 5% and a standard deviation of 10% (2x the return), it would mean the following in terms of what kind of returns this kind of portfolio experienced over a time period of the last 100 years:
About 66 out of 100 years, the return of the portfolio was between -5% to 15% (plus 1 standard deviation of 10% from the average of 5% and minus 1 standard deviation from the average of 5%)
About 31 out of 100 years, the return of the portfolio was between -15% to 25% (+/- 2 standard deviations)
About 3 out of 100 years, the return of the portfolio could was -25% to 35% (+/- 3 standard deviations)….think 2008.
If you’re lost for bored at this point, I understand. But, I imagine that you might be less bored when the portfolio does lose 25%.
In our next article, we will talk about ways to decrease standard deviation without compromising return AND HOW TO GET A FREE MEASURE OF THE RISK OF YOUR PORTFOLIO.
