Weighing all the risks
By Chris Evers
To balance risk and return within your investment portfolio is important. One side of that teeter totter is straightforward and self-explanatory: Return. But what about risk? What is it, and how do you know if you are balancing it correctly?
Intuitively and most accurately, risk in the financial markets is the threat of permanent loss of wealth.
However, financial analysts describe risk as volatility, or the standard deviation in the returns of an asset. In those terms, an asset that jumps around in value more drastically is riskier. Analysts can thus measure the amount of risk in a given investment using beta, which compares the volatility of an asset or basket of assets to an index, such as the S&P 500.
For instance, you would expect an asset with a beta of 1.2 to rise 1.2% for every 1% gain in the S&P. For every 1% decline in the S&P, the asset would decline 1.2%.
Using beta, investors can effectively weigh the risk and return characteristics of their portfolios. But volatility alone does not capture the entire risk picture. Investors may need to weigh it alongside other factors of risk.
Consider an individual stock that has a beta of 1.2 and also a mutual fund of 50 stocks with a beta of 1.2. According to their beta measures, these two holdings have the same amount of volatility.
However, that individual stock is far riskier. Unforeseen circumstances can derail even the most respected company and result in bankruptcy, causing investors to lose everything. That is practically impossible in a basket of 50 stocks. Yet, the two holdings have the same beta.
Beta is great at measuring risk when you already have a broadly diversified portfolio with exposure to many sectors, countries and even currencies, but it does not paint the whole picture when looking at an individual holding.
Age and withdrawal needs
Volatility can mean different things to different investors based on their phase in life. For a young investor with 20 or 30 years to invest before retirement, short-term volatility is less of a risk because they have more time to recover from a downturn.
In fact, volatility or beta should be viewed alongside cash flow needs. For investors who have reached retirement age or who may need to take regular distributions from their portfolios, volatility poses a greater risk. Withdrawal needs can force them to sell assets when values are low.
This is why a balanced portfolio is even more important for investors nearing retirement and those already in retirement. Being able to draw from dedicated safe money in an asset class such as fixed income allows you to avoid selling out of equities at an inopportune time.
Short-term volatility may not be the best measure of risk for a younger investor, but it can lead to another form of risk: Emotional risk.
Volatility can push some investors to overreact and jump out of the market at precisely the wrong time. That results in long-term underperformance and even the possible loss of accumulated wealth as skittish investors tend to sell at the bottom and buy at the top.
If an investor is unable to stomach the swings of a more volatile portfolio, then balance is imperative to smooth out the equity market swings and make it far less likely that the investor encounters emotional risk.
In the end, volatility and beta are powerful tools for investors not only because they provide a way to quantify risk but also because they force investors to ask introspective questions.
Risk is a personal variable. Without a thorough understanding of your cash needs, time horizon and emotional tolerance for market swings, that volatility measure is just a number.
Good advisors assess these personal characteristics through the lens of your investing goals to develop portfolios with the appropriate balance between risk and return to provide the most likely route to success.
Chris Evers is a registered representative and associate at Landaas & Company.
(initially posted Aug. 20, 2015)