Reducing Your Investment Risk

Let’s talk about risk for a second.

What’s it mean to you? Is it the loss of your money or maybe it’s the lost chance to make some. Everyone has a different way to define and measure it shaped in large part by our experiences and family history.

Now, when I talk about risk with a client I explain that I think it’s the chance of not meeting your goals. Intuitively, we all understand that all of investing – just like all of life – has risk associated with it. But just because we all know that risk is a natural part of life and investing doesn’t mean we like it. It makes us uncomfortable. It’s something that we prefer to avoid.

While that may be a natural instinct, we also know that we will not grow or move ahead in investing or anything else we may do unless we take action. So the greatest risk of all to financial success may not be the loss of something but taking no risk at all to achieve your goals.

So how do we best deal with financial risk? We have to strike the right balance between fear and greed.

While everyone may have their own way of measuring risk, when it comes to investing we do this by measuring “standard deviation.” What we look for is the standard deviation of an investment’s monthly returns. Remember this from your stats class? One standard deviation from the average means that 68% of all returns will fall within that range. So for an investment with an average return of 5% and a standard deviation of 10, that means that 68% of the time the returns will fall between +15% to -5%. Of course, those instance where the returns fall above the average are welcome by investors. Investors like those kinds of surprises.

How to Reduce Risk: Diversify and Lower the Overall Standard Deviation

So how do you reduce risk? You invest in enough assets that don’t move in tandem with one another. Think zigging versus zagging. Less correlation of returns means higher diversification.

Here’s an example to illustrate the point:

stock 1 sample

Here Stock 1 has the following risk/return measures:

Risk (Std Dev): 0.71%

Average Return: 5.00%

stock 2 sample

Here Stock 2 has the following risk/return measures:

Risk (Std Dev): 1.43%

Average Return: 5.00%

So to build a portfolio with stocks, bonds or mutual funds – the asset class doesn’t matter but the math used is all the same – you combine the different elements in a way that mutes the impact of volatility of these returns and thus results in a lower overall portfolio standard deviation.

A perfectly negatively correlated portfolio would have some investments that went up 1:1 for those investments that went down. A perfectly positively correlated portfolio would have all the investment tend to move up or down in the same direction together even if not moving to the same level of magnitude.

In this two-stock (or two mutual fund) example noted above, what happens when you combine the two?

stock 3 sample

The resulting portfolio produces a standard deviation of 0.78% (compared to 0.71% for Asset 1 and 1.43% for Asset 2) but with the same overall expected return of 5%.

While past performance is not a projection of future results, we can get an idea of how a portfolio will respond based on the math.

So to reduce your risk, get to know the numbers. You may find tools available to help you determine the statistics of your investments. Of you can use the help of a professional with access to powerful analytical tools. Whether you do it yourself or get the help, it’s important to understand what’s driving your returns and how much risk there really is under the hood.

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