What’s Your Risk? Figure It Out Now

1399350_s Nearly every move you make in life involves some risk. Driving your car, crossing the street, even boiling a pot of water. These are all things that we need to do in order to live our lives, despite the fact that there is danger involved. For the most part, we do what we can to mitigate those risks. We wear seat belts, we look both ways crossing the street, and we use potholders with care to avoid getting burned. But then there are those who drive high-speed motorcycles and bungee jump from bridges. They have, what I would call, a higher tolerance for risk. Hey, it’s their choice, right? If they feel that the “reward” of falling headfirst from a bridge and being yanked back up before impact is worth the risk involved, more power to them.
This concept brings me to our discussion today—understanding risk-adjusted returns. Investing in the stock market always has an element of risk. Yes, we are in uncertain times, no doubt, and the risk is more apparent now than it has been in recent years. The question you need to ask yourself is whether you are taking on more risk than you are comfortable with. Look, if you aren’t the bungee-jumping type, understand that you do not need to be. And as painful as volatility is at times, it can also be a good way to help figure out what your true risk tolerance is. The only thing scarier than free falling after you take the jump is standing on the bridge about to take the plunge and not knowing what to expect. Understanding your risk is the first step in understanding your portfolio.
If you are like most people, you probably evaluate your investments only in terms of their returns. However, you should ask yourself whether your investment returns are worth the risk involved in obtaining them. Ask yourself if your returns, compared to the returns of what would be considered a risk-free investment, for example, Treasuries, are high enough to justify the risk associated with them.
Recently, Roger, a gentleman from Brewster, called my office to schedule some time for us to speak. Roger was extremely concerned with all of the volatility in the markets over the past two years and has been especially concerned since January of this year. He is 58, self-employed, married, and wants to retire in five years. Roger told me that he had asked his current broker how to limit his risk, and his broker said to just hang in there.
Hmm, like hanging from a bungee cord.
So, before his appointment, I completed a portfolio analysis to see how Roger’s portfolio had performed over the last 15 years; I especially wanted to know how it performed, or behaved, during the Lost Decade of 2000-2010 and from late 2014 to today, two time periods that were very difficult with respect to performance. Initially, I asked Roger how he thought his portfolio had performed over the last 15 years. Roger proudly told me that since 2000, his portfolio had earned an average of about 5 to 6 percent a year. I explained to Roger that although this may be true, his annual returns have been very uneven; one year his return may have been 11 percent, another year it may have been down 38 percent. I then explained to Roger some strategies that have also averaged a 5 to 6 percent annual return during the same time frame, but with returns that have been more predictable. While both strategies had volatility, the latter managed the downside risk a bit better, helping to provide more consistent returns.
Now, you might think both would end up with the same amount of money after 15 years, but that’s not the case. Cumulative performance depends in part on the timing and size of the declines in a portfolio, not just the average returns. A big loss in the first year or two of a defined time period results in valuable time spent recovering from that loss, rather than making the most of compounding interest; and that, my friends, can affect future growth. That’s why it’s important to consider an investment’s risk-adjusted return.
I explained to Roger that one of the most common measures of volatility and risk is Standard Deviation, which gauges the degree of an investment’s up-and-down moves over a defined period of time. It measures how much the investment’s returns have deviated from its own average over that time period. The higher the standard deviation of an investment, the bumpier the road has been to achieve those returns.
Another way to assess an investment’s risk is to look at its Beta. This compares a portfolio’s ups and downs to those of a benchmark index, such as the S&P 500, and indicates how sensitive an investment might be to overall market movements. An investment with a Beta of 1 would have exactly as much market risk as its benchmark. The higher the Beta, the more volatile the investment, compared to its benchmark.
Standard deviation and Beta are just two of a handful of ways to measure the risk of an investment. Understanding your portfolio’s overall risk helps to answer those important questions we talked about above: Are your returns high enough to justify the risk you have assumed? What is your reward? Is the “fun” of bungee jumping worth the risk?
Folks, as I tell my kids, you can’t get anywhere in life without taking risks. While understanding risk does not necessarily minimize it, understanding it can help you evaluate whether the return you are trying to achieve is worth the risk you are taking. Roger was assuming all the risk, with returns that were not significantly higher than strategies with similar returns, but lower risk.
What’s your risk? Now is the good time to figure that out.
Be vigilant and to stay alert, because you deserve more.