Most investors fear risk. That’s why so-called “safe” investments are so popular. When stock markets decline in value it is not unusual to see investors fleeing to annuities and CDs. The fear is that stocks will continue to fall in value and these products can help “stop the bleeding.” What most investors don’t realize, though, is that there’s an upside to risk. In other words, risk cuts both ways.
People usually don’t think about risk until their investments have declined in value. When markets go down and deliver negative returns, the investor may declare that they really don’t like risk. But when returns are great, or they are experiencing the upside of risk, there is never a complaint. The point is that positive returns are considered risk too, because they are equally as unpredictable. Great returns with no risk would be wonderful, but these two concepts just don’t go together.
If we look through history, it is not unusual to see 30 or even 40% returns in some segments of the stock market. While we may look at such results with a sense of glee, a statistician would call that another form of risk. The typical investor doesn’t usually talk like that. They only think about risk in the negative.
The key is measuring the risk in your portfolio on the front end and knowing what to expect in the future.
While we can’t predict exactly what’s going to happen—or when it will happen—we can get an idea of the range of returns we can expect. If you know what to expect, you won’t be surprised when it happens!
How then do we know what’s an acceptable amount of risk?
Understanding Risk
Risk in investing is like the bounciness of a ball. Throw a bowling ball up in the air and you know where it’s going to end up—exactly where it lands. Throw a small rubber ball, however, and who knows where it will land? It might be up, it might be down, it might be left or right. The bouncier the ball, the more variation in where it will land.
This variation is like risk in investing. Risk means volatility—how much up and down can we expect in an investment. We use a number called standard deviation to measure this up and down—the bounciness—of our investment portfolios. I know what you’re thinking. “Standard deviation sounds too technical for me.” But let me make it simple, because once you get this, you unlock the key to becoming a confident and disciplined investor.
Stocks can go up 30% in one year, and down 30% in another. We all get that. Standard deviation is assigning a value to this volatility. The higher the number, the more a portfolio can go down, but also the more it can go up. The lower the number, the less it goes up and down. In short, a higher standard deviation means a riskier portfolio, both with low and high returns.
Let’s look at how this works in a little more detail, and then we’ll see how we can use it to make better investing decisions.
To understand how standard deviation works, we need to understand expected return. When we talk about future returns, we always talk about expected return, because they’re unknown. It’s only the insurance industry that can get away with something like, “We’re going to guarantee you a 5% rate of return.” Even though that’s a very misleading statement, but that’s for another time.
The details of how expected return is calculated can be for another blog too, but investment academics run statistical analysis throughout history to come to these numbers, and they are very accurate. If you give a list of investments—stocks, bonds, mutual funds, whatever—we can tell you how much return you can expect from that investment mix over long periods of time.
For example, we might conclude that a portfolio has an expected return of 7. That doesn’t mean it will be 7 each year, though. It might be 10, then 2, then negative 12, then up 30—it can be all over the place, but it’s expected to be 7 over the long-run.
This is where standard deviation comes in. It tells us how much variance there can be from year-to-year in the returns.
Measuring Risk in an Investment Portfolio
You can plug investments into a computer program, and it will tell you the standard deviation and expected return. With those numbers, I can find the range where all my returns will land. Here’s how it works.
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If I have a diversified portfolio of 60 percent stocks—large, small, and value companies in both US and international—I might have an expected return (depending on inflation) of about 8%, and a standard deviation of about 11.
To find the possible variation in return—the amount of risk in my portfolio—first, I add the standard deviation to the return, so 8 plus 11 is 19. Then, I subtract the standard deviation from the expected return, 8 minus 11 is negative 3. This gives me a range of returns: from negative 3 to positive 19, and it tells me that 68% of my yearly returns should be between those 2 numbers.
- Standard deviation + expected return
- Standard deviation – expected return
= the range where 68% of my returns should fall
You can do this with any portfolio if you have the expected return and the standard deviation. There are 3 number ranges. The first is 1 standard deviation away from the expected return—add it to the top, subtract it from the bottom, and this gives you the range—68% of the returns fall within 1 standard deviation. 95% of returns should fall within 2 standard deviations, and 99.7% of returns should fall within 3.
- 1 standard deviation away = 68% of returns
- 2 standard deviations away = 95% of returns
- 3 standard deviations away = 99.7% of returns
So, for this portfolio, 95% of returns are between negative 14 and positive 30—2 standard deviations away from the expected return of 8—and 99.7% of all my returns are within negative 25 and positive 41—3 standard deviations. And who said statistics was hard?
Here’s how it looks visually:
Everyone wants the risk of a 41% return, but it goes along with the risk of negative 25. People get too focused on the negative, and so they attempt to run toward safety. They might go for an annuity that has no volatility, but it’s return is 3%. When you realize inflation might be 3 or more, you can see how annuity returns can be like trying to make a basket by bouncing a bowling ball off the ground.
What happens when I get the negative 14 percent return and I’m not aware of this concept? I’m tempted to run and sell! Not realizing that this return was completely normal. If I sell when my investments gave poor returns, I’m selling low, and I lose the chance to ever get the positive returns. But once you understand this concept, you won’t run at the first sign of “risk”, and you give yourself the opportunity for all the possible future positive “risk”.
Since my expected return is positive, more of the returns are positive than negative. Also, the positive returns are bigger than the negative ones. In fact, about 66% of returns are positive. But if you bail every time there are negatives, you never get to experience the positives.
This concept is even more powerful when you look at longer time periods.
Multi-Year Standard Deviation
Single-year returns are not very important for a disciplined investor. We invest for the long-haul, and so I want to know what my long-term expected return is, and how much variability I can have over that period. What can I expect my returns to look like over 5 years? That’s still short. What about 20 years? 30 years?
Longer time periods mean less variability in return, meaning the returns get closer and closer to that expected return, 8 in this case. This helps us stay disciplined, because a single year can be all over the place, but the total return over a longer period starts to narrow in on that single number.
There’s a cool trick we can use to figure this out. For whatever time-period I’m looking at, I take the square root of that number of years, and then I divide my standard deviation by that number. This gives me my new standard deviation for the longer time period.
For example, how much volatility can I expect in this portfolio over 4-year periods? The square root of 4 is 2, divide 11 by 2, and that gives me 5 ½. Now, 68% of my 4-year returns fall between 2.5 and 13.5. Those are some numbers I can get behind! For a 16-year period, square root is 4, 11 divided by 4 is 2.75, so 95% of all my returns in 16-year periods will be between 2.5 and 13.5 (2.75 times 2, add it to the top, subtract it from the bottom).
You don’t have to memorize all the math but knowing the logic behind the randomness of investment returns is valuable, especially as we face difficult periods of return.
Difficult Periods
I was talking to a college professor who teaches financial planning to advisers around the country. He used to work for a big investment firm, and I asked him why he got out.
He was in asset management, and the company that he was using was a very active manager. He constantly had to teach clients because they were saying, “I need THIS rate of return,” and the returns coming through weren’t what they wanted. Sometimes the returns were higher than what the client expected or what they were told was likely, but sometimes they were lower. Every time they were lower, oh my goodness, all heck broke loose.
These clients were only calling when returns were down.
We kept talking, and he asked about how we dealt with other difficult periods in history—’02 and ’08 and those types of things. I said, “The education process.” When we first start managing a client’s portfolio, we are adamant about setting their expectations regarding returns. Now, some people may not listen. They may plug their ears when you tell them that it could go down and how much, what level of volatility is possible, and so on. But you do so much educating of the client beforehand, then when it happens, it’s like, “Oh, Paul told me that could happen.” That is key because here’s what happens: Markets have always come back from a downturn because there are so many factors pushing them to bounce back.
Stocks Can Recover
When economic conditions are tough, a company will say, “We’re laying off half the workforce. We’re shutting down the factories”. It might not be good for the economy, or your politicians—or the people they laid off—but the stocks go up. Why? Because the CEO’s job is to get the stock price and the earnings back up, at any cost.
This is critical because everything in the economy might be falling apart, and everyone is panicking, but stocks might be right on the verge of a major upswing, and you get to be there when it happens, IF you stay disciplined. There won’t be evidence that anything good’s going to happen in stocks. The evidence will be that everything’s going to be terrible. The media will be talking about how bad the economy is, yet stocks recover.
Why? Because they are leading economic indicators, meaning they go up before the economy recovers. The economy is not a predictor of the stock market; it’s the other way around. The stock market anticipates that these layoffs will increase profitability in the future, not because the economy’s good, but because expenses are lower.
Investors fear risk because it’s unknown and out of their control. But when you accurately measure the risk in your portfolio and understand its upside, you can move one step closer to relaxing about money.
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Written by Paul Winkler
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