What's Your Budget for Risk?

November 16, 2011 RSS Feed Print

Kelly Campbell

Risk as derived from its Italian origin “risicare” means “to dare.” If most people thought of their portfolios as a dare, they would probably keep their money in cash.

The interesting concept about risk is that people don't have a clear way of measuring it. It's not that one doesn't exist or that they don't know how to measure it; they simply don't think about risk logically.

Most everyone learned about standard deviation in high school and/or college. You remember the bell curve? Recall from your favorite class that the higher and narrower bell, the better the return with less volatility. In contrast, a low, wide bell curve was one with more risk and less return.

So how do you use standard deviation to measure your portfolio's risk? Begin by looking at the risk of certain asset classes. From 1970 to 2010, the standard deviation of the S&P 500 was 18.1, while for a corporate bond index it was approximately 6.7. For cash, it was 3.2. The corresponding annualized returns for those three asset classes were S&P 9.9 percent, bonds 8.3 percent, and cash, believe it or not, 6.0 percent.

[See 3 Reasons to Hold Cash NOW.]

In building a good portfolio, you want to include asset classes that are different from one another and that have varying levels of risk. The more truly diverse the asset classes, the lower the standard deviation, the volatility, and the risk. A less risky portfolio helps you sleep better at night.

So if you have a portfolio of 1/3 S&P 500, 1/3 bond index, and 1/3 cash, compared to the S&P 500 alone, you would see a lower standard deviation and more consistent annualized return. In this case it was 9.33 and 8.07 percent respectively.

Now let's drill down and see what the standard deviation is telling us. Referring back to the bell curve, the vertical line right through the center of the bell is the average of the returns. The width of the bell determines how many standard deviations all of the returns fell from the average (also known as the volatility). Remember also from your statistics 101 class that 99.6 percent of the time, the returns of the market in this case fell within three standard deviations of the average. Following me so far?

In the S&P example, the returns averaged 9.9 percent and the standard deviation was 18.1. That means your annual returns over that period fell between negative 44.4 percent and positive 64.2 percent. That represents a huge swing in returns.

If you would have opted for the three-investment portfolio, your average return would have been slightly lower at 8.07 percent, but it would have been much less volatile. It would have fallen between negative 19.92 percent and positive 36.06 percent.

As you can see, simply adding differing asset classes can significantly reduce your risk while keeping your return relatively high. This is the key to investing for consistent returns.

Hope this will get you to think differently about your portfolio and the investments you choose to include.

Good luck and happy investing.

Kelly Campbell, CFP® and Accredited Investment Fiduciary, is founder of Campbell Wealth Management, a Registered Investment Advisor in Alexandria, Va. Campbell is also the author of Fire Your Broker , a controversial look at the broker industry written as an empathetic response to the trials and tribulations many investors have faced as the stock market cratered and their advisers abandoned their responsibilities to help them weather the storm.