Last week we introduced the concept of Modern Portfolio theory – the idea that a good portfolio considers how different funds work together to balance the risk-return tradeoff. This week we’ll continue that conversation by discussing what risk is and why it’s an important aspect of building a good portfolio. As I mentioned last week, many investors and a surprising number of advisors focus solely on returns when it comes to building a portfolio. While you certainly want a portfolio that generates decent returns, you don’t want to ignore the risks that come with.
The easiest way for investors to measure risk is by how volatile an investment is – how much it moves up and down. Mathematically, we use the concept of standard deviation – how much a fund’s returns deviate from its average returns – to measure volatility. Typically, high returns are associated with high risk meaning a stock with higher returns will usually exhibit a lot of volatility. To give you an example, consider the following graph:
The blue line shows returns for Vanguard’s small-cap index and the green line shows a bond index. Historically, small-cap investments have exhibited some of the highest returns of any investment class but they’re also very volatile as you can see from the crazy swings of just the last year. Conversely, bonds typically return less than stocks but are also less volatile as shown by the smoother green line. Most investors can’t stomach the major volatility that comes from a high returning asset class like small-cap, but they also need their portfolio to generate enough returns to fund their financial goals. The solution is to bring the different asset classes together to create a portfolio that meets an investor’s return objectives but also has a risk profile that allows an investor to stick with their portfolio and not sell out during the downturns.
If you’d like to learn more about the different types of risks inherent in a portfolio, you can check out a previous article series we did on risk (inflationary risk, interest rate risk, drawdown risk). If you’d like to talk to an advisor about the risk profile of your portfolio give us a call.