Understanding the nature of investment risk can help you plan for it.
From 2003 through 2006, the U.S. stock market enjoyed a prolonged period of relative calm. Many investors without a sense of history may have assumed that investing had become less risky. Indeed, many articles in the financial pages claimed that stocks would offer lower returns in the future to reflect lower risk. Something in the market had changed, many proclaimed.
Since the February market retreat earlier this year and subsequent recovery, it now appears that stocks may be returning to a more normal level of volatility. This is apparent by the larger swings and new record highs in the market indexes. We are not surprised and hopefully our clients are not either. Our investment philosophy focuses on containing risk in a portfolio.
With this in mind, we would like to review the basics of risk. In today’s media-saturated world, it’s often easy to lose perspective.
Risk assumes many forms in an investment portfolio. Some risks are clear and measurable, while others are more elusive, though just as potentially harmful to your wealth if they are not managed properly.
Two forms of risk
All types of investment risk fall into one of two categories—those you can eliminate and those you must accept as a part of the investment experience.Â The first type of risk—systematic risk—affects an entire investment class, and includes interest rate movements (interest rate risk), reduction of purchasing power (inflation risk) and general market pressures (market risk). Investors can do nothing to reduce systematic risk because it is a shared characteristic of an entire market or asset group.
Since this inherent risk cannot be diversified away, investors expect to receive a higher return as an incentive to accept it. So, for instance, stocks are considered riskier than Treasury bills and have offered a higher average return over time to compensate for this risk.
Another type of risk, called unsystematic risk, refers to factors affecting a specific investment. For instance, poor management decisions could destroy a company’s strategic market position and result in lower earnings and reduced stock value—a situation that would be unique and specific to that company. Another example is a bond that defaults because the borrowing company fails to pay.
Volatility as risk
Within a portfolio, both forms of risk are most commonly measured by standard deviation—or the degree to which the portfolio’s return fluctuates from its long term average. This is also generally known as volatility or variance.
Over time, a portfolio’s value will change as the various component investments deliver different returns. To understand the impact of volatility, consider these principles:
Rule 1: Any percentage loss requires a larger percentage gain for recovery. For every percent loss level, a larger percent gain is required to return the portfolio to its original value. For instance, if your $100,000 portfolio loses 10%, it must subsequently earn about 11.1% to fully recover. Look at this another way: A 10% loss reduces your portfolio to $90,000, but a 10% rebound lifts the portfolio to only $99,000. You need an 11.1% increase to reach $100,000.
Rule 2: The percentage gain needed for recovery grows as the percent loss increases. The return needed to recoup a loss grows disproportionately higher as the loss increases. This is because you have less money working for you after the drop.
For instance, the 10% drop requires an 11.1% rebound; a 25% loss requires a 33.3% rebound; a 50% loss requires a 100% return; and a 75% loss needs a 400% rebound. So, negative compounded growth can work against you.
Rule 3: Higher volatility drags down performance. If you could choose between two portfolios with the same average return, the one with the lower volatility would be preferred. The more stable a portfolio’s return, the higher the compounding rate and annualized return over time.
The adjacent chart demonstrates this principle by illustrating the results of two hypothetical investments having the same 10% average return over three years. Portfolio A experiences actual returns of 20%, -10% and 20%, while Portfolio B earns a steady 10% each year. Although both portfolios average 10% annually, Portfolio A’s fluctuation translates into a lower cumulative return (29.6% vs. 33.1%). As a result, Portfolio A has a 9% annualized return and Portfolio B a 10% annualized return. (Annualized return is the average percent return realized each year to reach the total portfolio value over the three-year span.)
Volatility is why these portfolios have different cumulative returns but the same average annual return. Portfolio A’s cumulative return line rises and dips along its bumpy three-year course (20%, 8% and 29.6%). Consequently, its annualized rate produces a lower return (9%, 18.9% and 29.6%), which is plotted along the dashed line. Portfolio B’s higher slope (solid line) reflects its 10% annualized and average return.
If volatility is such a dominating force in wealth accumulation, investors should structure their holdings to reduce return variation over different periods. The primary tool is through diversification strategies. By holding a sufficient number of securities within each asset group—and several asset groups that don’t perform the same way in a given market environment—you attempt to smooth out the effects of market volatility over time.
Our passive investment strategies are designed to get the most from compensated risks. The enhanced asset classes we employ in portfolio design are structured to reduce diversifiable risk and provide exposure to various market components that, in combination, can reduce volatility and boost total investment return over time.
Investors should consider portfolio stabilization as more than a defensive technique. It’s also a tool to enhance return. You cannot eliminate volatility in the real world. But you can reduce the frequency and magnitude of return fluctuation through portfolio design. This is the best way to manage risk.