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Have you ever heard your buddy brag about how much money he made on “X” stock? It usually goes something like:
“I bought Intel when it was trading for mere dollars. Then I sold it at the peak and had a 500% return on my money!”
Here are some things your buddy probably didn’t tell you:
- That he only used about $500 of his $600,000 portfolio to buy shares. So his overall portfolio return attributable to this investment is quite small.
- That time he bought Enron stock and lost all of his investment.
- The amount of risk he had to take to generate the return on his Intel investment
And point number 3 is the one we need to focus on today. In order to generate return on investment you have to take risk. And the expected return should be in line with the amount of risk.
Risk / Return Tradeoff and Investing Your 401k
An investor does not willingly take on risk unless they expect to generate a sufficient return. Think about this for a moment. Bank CD’s are currently very low, around 1%. But they have virtually no risk thanks to the FDIC.
But what if they were extremely risky and volatile? What if the expected return was only 1%, but there was a good chance by the end of the year you could lose 20% of your original deposit?
No one would buy in to such an investment. If you are going to take on a lot of risk, the investor wants to be compensated for it.
That’s what the Risk / Return Tradeoff is all about.
Things To Keep In Mind When Investing Your 401k
There are factors that can make you more comfortable (as well as less comfortable) with the amount of risk you take in your portfolio.
A longer time horizon can make an investor more comfortable taking on more risk. That’s because if the investment goes down there is still plenty of time to make up for the decline. Therefore, it may make sense to be invested in a more risky asset that has a higher return potential.
A shorter time horizon can make an investor more risk averse. If I’m setting aside money to use as a down payment on a home I will purchase in one year, then I am very risk averse with that money. In one year I need it. I’m not going to invest in things that are risky and could be worth less in a year.
This is why time horizon is a driving factor that causes retirees (and those approaching retirement) to become more risk averse. When a person retires they usually have to make withdrawals from their portfolio to supplement Social Security. Since they need to withdraw this money, they don’t want it to fluctuate too wildly in the market.
Also, the potential to be able to replace funds plays a role in how much risk you’re willing to take with your investments. Again, for retirees their savings are typically not replaceable. It’s hard to replace your savings if you are not drawing a salary and using that salary to make additional contributions to your portfolio.
This is just the nature of retirement. And so it makes most retirees more conservative in their investments.
So How Do You Measure Risk in a Portfolio?
The most common way of measuring risk in a portfolio is through a mathematical term called “Standard Deviation.”
It is simply a measure of how much an investment’s returns deviate from the average return. You could have 2 different investments, each with a 10 year average return of 8%. But if one investment consistently makes 8% exactly every year, then you can see its annual returns each year never deviated from its 10 year average.
In other words, that hypothetical investment had tremendous predictability and little uncertain.
But if the other investment had annual returns all over the place, (say 30% one year, -20% the next year, etc.) it would have a higher standard deviation. It would be riskier because you wouldn’t know what the results would be in any given year. And some years your portfolio could be at a large loss.
Even though it’s 10 year return averaged 8% annually, it had a larger standard deviation. It had more uncertainty, and hence more risk.
A large standard deviation shows that the investment can deviate wildly each year from the expected normal annual returns.
The lower an investment’s standard deviation, the less volatility it has. For most investors, less volatility is comforting, especially for retired investors.
Some Things To Keep In Mind
Standard deviation is an historical measure. It is simply looking at an investment’s past performance and making a mathematical calculation. It does not mean that the investment will have that same standard deviation in the future.
However, historically we know that certain investments tend to be more risky (i.e. volatile / uncertain) and it makes sense they will continue to be going forward over the long term.
For example, a small up-and-coming company will typically have a higher standard deviation than an established large company.
A high risk venture, like a tech start-up, will have more risk (uncertainty) than a 30 year government bond. Therefore, stock in the new tech start-up will be more volatile. It has potential to return a lot, but it also has potential to crash and burn and lose everything. A 30 year US government bond doesn’t have much upside potential, but it is safer.
Managing Risk for Retirees
One way to help decrease risk in your portfolio is through diversification. Individual securities (like a company stock) can have high volatility. But when you diversify across multiple companies (such as buying an index fund that tracks the S&P 500) it can help reduce the volatility.
But an investor can help reduce volatility further by diversifying across different asset classes, such bonds, commodities, REITs, etc.
While an individual asset class may have higher volatility, when it is part of a properly diversified portfolio it can help balance out what the other investments are doing. It can be the Yin to the other investments Yang, and vice versa.
Don’t get jealous of your buddy who invested in some hot tech stock, made some money then sold out before it crashed. Your buddy probably got lucky, probably didn’t put too much actual money in the investment, probably lost on other occasions they aren’t telling you about, and probably took on way too much risk to justify the return.
A smart, disciplined investment strategy is the way to go long-term. This means using diversification to your advantage. It means having a plan in place to know when to buy and sell, and not just going off a “gut feeling.”
It also means having an asset protection strategy in place like we do for our clients with Wealthguard™.
There’s always a risk return trade-off. Returns aren’t everything. What level of risk did you have to take to get that return? Was it worth it?
That’s what every retired investor should be asking themselves.
That’s where we can help you. To get a free report that shows the risk and return of your current portfolio hop on my calendar by clicking here. Are you getting compensated for the amount of risk you are taking? Find out now.