Many Investors seem to know their approximate rate of return, but probably don’t know how much risk they are taking to garner the return they receive. The goal for most is to get the highest return while taking the lowest amount of risk. This can be much easier said than done, and it’s important that investors understand their portfolio’s relationship between risk and return.
The most common way of measuring risk in a portfolio is through a mathematical term called “standard deviation.” This is simply a measure of how much an
investment’s year-to-year returns differ from the average return.
Let’s take two different investments, each with a 10-year average return of 8%. If Investment A consistently makes 8% exactly every year, then you can see its annual returns each year never deviated from its 10-year average. In other words, Investment A had tremendous predictability and little uncertainty.
But if Investment B had annual returns all over the place, (say 30% one year, -20% the next year, etc.) it would have a higher standard deviation even though its 10-year return averaged the same 8% annually. It would be riskier because you wouldn’t know what the results would be in any given year. Some years your portfolio could be at a large loss.
The lower an investment’s standard deviation, the less risk and the less volatility it has. For most investors, less volatility is comforting, especially for retirees.
It’s good to keep in mind that standard deviation is a historical measure. It is simply looking at an investment’s past performance and making a mathematical calculation. It does not mean that the investment will have that same standard deviation in the future.
One way to possibly help decrease risk in your portfolio is through diversification. Individual securities (like a company stock) may have high volatility. But when you diversify across multiple companies in different sectors (finance, healthcare, etc.) it may help reduce the portfolio’s overall volatility.
Additionally, an investor may help further reduce volatility by diversifying across different asset classes, such as bonds, commodities, etc. While an individual asset class may have higher volatility, when it is part of a properly diversified portfolio it can help balance out what the other investments are doing. It can be the Yin to the other investments Yang, and vice versa.