Paige Radke: So, what I’m going to do is do just a little bit of a deeper dive into the trade-off between risk and return.

Everybody throws around the phrase, “no risk, no reward.” But it’s oftentimes difficult for individual investors to fully wrap their head around what that trade-off actually looks like and what it means for them.

What I really didn’t want to do today was stand up here and start spouting off the importance of alphas, betas, Sharpe ratios and R-squared because those technical factors, those are our job to keep an eye on.

But I do think that in today’s environment of heightened volatility, it’s especially important to revisit that concept of risk and, specifically, what it means for you and how you should look at it.

Return is completely dependent on risk. Yet, most people put a huge emphasis on the returns of their portfolio. It makes sense though, right? It’s a number that’s easy to figure out. It’s one of the most commonly looked at numbers at the bottom line of every report that you see. It’s an easy number to talk about and compare to that of your friends, family or just the market overall.

But what’s often lost on individual investors, as they’re making those comparisons, is the amount of risk that you’re taking in order to get those different levels of returns.

So often, we hear questions from clients like, “Why is my portfolio only up 10% when the market is up 15?” And the answer to that question always has to do with the amount of risk you’re taking. The definition of risk as it pertains to you and how I’d like you to think about it is basically any certainty with respect to your investments that has the potential to negatively impact your financial welfare.

You have to ask yourself with every investment that you make, “Is that additional return that I’m going to get worth the risk of more volatile returns as well?”

It’s important to remember that all assets have an inherent level of risk associated with them—and that the level of return that you get is directly related to that level of risk.

So, on this chart here, you have return versus risk. High-yield bonds have a higher return than investment-grade bonds, which have a higher return than short-term bonds. But to get those higher returns, you have to move along the risk spectrum to get there. That same concept applies when you look at U.S. large cap to U.S. mid- and small-cap, and then all the way over to the emerging markets.

Even cash carries risk. You have the risk that you won’t keep up with inflation. And you have the risk that you just simply cannot meet your financial goals by just putting your money away in a mattress.

All bonds carry interest rate risk. So, the risk that interest rates will go up and your bond prices will go down. With high-yield bonds, you also have to add in that added risk, that you just won’t get paid back at all. In various stock markets, you have a risk that can impact an individual company, a country, or just overall market issues in general. So, these are all things that you have to consider when investing. Are those extra risks worth the return that you’re getting?

So, while the risks behind each individual asset class that you’re going to look at is the same for all investors, each and every one of you has a different situation that determines your tolerance for the degree of uncertainty and variability that you’re able to withstand—or risk. You simply cannot get average or above-average returns without also taking average or above-average risk. It’s mathematically impossible to do so.

But what we can do is figure out the proper level of risk for you to take.

There are some measurable factors associated with that, like time horizon, cash needs, how much money you have to invest overall. But there’s also some psychological factors associated with that like life experiences. Or how did you feel the last time the market took a downturn?

There are questionnaires and things like that, surveys that you can take to try to figure these things out. But, ultimately, the best judge is yourself. So, you have to look back at time periods like, let’s say, the fourth quarter of 2018. We experienced heightened volatility. The market took a downturn. How did that make you feel? Were you confident that you were still going to meet your financial goals? Because the last thing that you’d want to do is react to have something that could ultimately, then, negatively impact your financial future.

So, as I just said, everybody has their own tolerance for risk. But Morningstar still breaks risk tolerance down into five general categories ranging from conservative all the way up to aggressive. (Shows chart.) This is basically just another way to view the efficient frontier graph that Bob talked about earlier. But in this situation, we’re looking at a little bit of a shorter time period. This only represents about 10 years.

So, the numbers at the top of each bar represent the mix between stocks and fixed income and cash. The black dots show the returns that you can expect on average from these different risk levels. And the bars represent how much you can expect these returns to vary on average.

Now, that’s not to say that the returns are always going to fall within these bands. They could go outside of them. But on average, this is where you can expect to see your returns.

So, as I said earlier, the risk to an individual investor is the uncertainty of not being able to meet your financial goals.

As you move from the conservative portfolio to the aggressive portfolio, sure, your expected return goes up a little bit at each risk level, but the variability and, therefore, uncertainty of those returns also increases.

Take, for example, a conservative portfolio that has 20% in stocks and 80% in bonds. That’ll generate an average annual return of about 4.5%. But you can be pretty certain that your return is going to fall someplace within that range.

On the flip side, when you look at a moderately aggressive portfolio that has 65% in stocks and about 35% in bonds, that will generate an average return of about 9% but with much more volatility than the conservative portfolio. So, by adding those additional risky asset classes and moving up in that risk spectrum, sure, you may be doubling your expected return, but the uncertainty behind those returns has also more than doubled.

Now, you may be out there thinking, “Well, this is all good and well, but once I understand the trade-off between risk and return, and I figure out what level of risk I should be taking, what else do we do to help manage for those risks?”

So, that asset allocation that you determine based off of your risk tolerance is the broadest way that we can control for these risks. By having a set target asset allocation, you can more easily recognize when your portfolio may be taking on too much or too little risk.

Take, for example, if there’s been a big run-up in stocks. Chances are your portfolio now is taking on more risk than you can handle. So now, despite the fact that stocks may continue to go up—

this isn’t a call on whether we think the market’s going to take a downturn or keep going. This still triggers a sale of stocks and a shift to bonds and cash. And sometimes this also means taking a look at the holdings that you have and selling funds that may have underperformed because you just simply aren’t getting paid for the amount of risk that you’re taking.

Going down even one step further, we need to make sure that all your eggs are not in one basket. And we do that through diversification. The goal of diversification is to make sure that all your assets in your portfolio are not highly correlated. If you were here last year, you heard me talk about correlation in great detail. But the meat and potatoes of it is basically you’re not diversified if all of the assets within your portfolio are moving in the same direction and to the same extent all the time. This applies to stocks versus bonds, but it also applies to the categories within stocks and bonds like growth and value, U.S.-international. And even beyond that, it applies to the processes and mandates of the different funds within those categories.

If you want to take that down one step further, we also want to look at whether or not active managers are doing their jobs.

The primary benefit of investing in actively managed mutual funds is their ability to control for downside risks. With index funds, sure, you can expect to get 100% of that upside, but you trade that off by also having to expect 100% of the downside. Active managers have the ability to control for that downside risk. And we have the ability to monitor those active managers by looking at their risk control measures and making sure that they have good upside and downside capture ratios.

Essentially, I don’t care if a fund manager is going to significantly outperform on the upside if that means that they’re going to significantly underperform on the downside and experience greater losses than the overall market.

So that brings me back to my original question that we always get asked. Why is my portfolio only up 10% when the overall market is up 15? Because the return that you get is directly related to the amount of risk you’re taking. Since you have a moderate to moderately aggressive tolerance for risk, you have 60% in stocks and 40% in bonds.

This means you’re taking about 60% of the stock market risk, but through the other risk control measures like diversification and active management, you’re still able to capture 65% of that return. So, I don’t know about you, but personally, I would take that risk-return trade-off any day.

Paige Radke is a registered representative at Landaas & Company.
Money Talk Video by Peter May and Jason Scuglik

(initially posted October 18, 2019)

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