When deciding whether or not to use a particular medical treatment, a physician must weigh the risks against the potential benefits to the patient. As an investor, you need to determine whether an investment’s potential benefits are worth the risk to your portfolio’s fiscal health.
Risk vs. Reward
Investing always involves balancing risk and potential return, while taking into account the investor’s individual risk tolerance. Both risk and return can be determined from an investment’s historical data. Return is relatively easy to quantify. We’ve all seen those impressive looking charts showing how much $1,000 invested ten years ago in a particular mutual fund would be worth today. An investment’s total return should be compared to an index of like investment vehicles and should include its performance in both up and down markets and in various time periods. However, an investment’s past performance is not always a reliable indicator of future returns. Today’s hot stock or fund often becomes tomorrow’s market laggard.
Risk has traditionally been the neglected side of the investment equation. One reason is that measurements of risk are not as easily understood as measurements of return. Let’s look at some of the common measures of investment risk.
A quick way to get an idea of a stock’s or stock fund’s relative risk is by its beta. Beta is a measure of an investment’s risk against an index of the overall market such as the Standard & Poor’s 500 Index. A beta of one means the stock or fund has the same volatility as the index. A beta of .5 means the stock or fund is only half as volatile as the index.
Standard deviation is a measure of the variability of an investment’s actual returns from the average total return for any given time period. The greater the standard deviation, the larger the differences between actual total returns and the average total return and, therefore, the higher the risk. Standard deviation can be used to measure the volatility of any investment, whether it is a stock, stock fund, bond, or bond fund. As a result, standard deviation is a useful measurement of the risks of the different types of investment vehicles in your portfolio. For example, a bond fund with a standard deviation of three is only half as risky as a stock fund with a standard deviation of six.
In addition to standard deviation, a bond’s or bond fund’s risk is measured by its maturity. Maturity is the length of time until the bond matures or, in the case of bond funds, the average maturity of all the bonds in the fund’s portfolio. The longer the maturity, the higher the risk.
Of course, longer maturity bonds produce higher returns in a falling interest rate environment. A more accurate measure of a bond or bond fund’s risk is its duration which is the weighted average time to recovery of all interest payments plus principal. If market interest rates are rising, you should keep your bond investments in shorter maturities and durations. But, when rates are falling, bond investments with longer maturities and durations are the place to be.
Overall Portfolio Risk
Your overall portfolio risk is not only determined by the risk of each individual investment type, but by how they interact in various investment environments. The key to reducing risk is to find investment types that respond differently to market forces. You need to train yourself to think in terms of your overall portfolio risk to ensure your long-term investment success.