Risk and Reward

Warning: Not all risks are created equal.

In the investment world, there is an inherent relationship between risk and reward. Webster’s dictionary defines risk as “the possibility of loss or injury.” For investors, this potential for a loss is also the reason they earn a return. The more risk you take, the more you stand to gain over time. Unfortunately, not all risks are created equal. Nobel Laureate William Sharpe separated risk into two categories in his Capital Asset Pricing Model (CAPM).

The two categories of risk are systematic risk and non-systematic risk. Systematic risk (sometimes called market risk) refers to the risk associated with the entire market. This type of risk cannot be avoided and is the primary reason you earn a positive return over time. Non-systematic risk (sometimes called diversifiable risk) refers to risk associated with specific companies or types of investments.

It is important for investors to differentiate between the two risks b/c there is no additional expected return from taking non-systematic risk as compared to the expected return from systematic risk. In other words there is no potential reward for taking non-systematic risk. Systematic risk is the potential for reward. Non-systematic risk is just risk with no additional potential for reward. Therefore, it is imperative that you construct your portfolio for the amount of systematic risk you are comfortable with while avoiding non-systematic risk altogether.

Investors can avoid non-systematic risk thru diversification, so we will not bother discussing that further. Since investors cannot avoid systematic risk, it is important to create a portfolio that exposes you to the appropriate amount of that risk. If your portfolio is too risky, then you are likely to sell when the market goes south. If you are going to be successful at investing, then you need to have a long term investment strategy that you are not going to abandon in bad times. Successful investors understand the amount of risk they are taking and why they are taking it.

How do I measure risk?

Investment risk for different asset classes can be easily understood by looking at historical data over several decades. You can compare the risks of different types of investments by comparing the standard deviation of historical returns of each of those investments. A quick review of standard deviation will help explain this.

The graph below shows the standard deviation of a normal distribution curve. The symbol µ represents the mean or average. The symbol σ represents standard deviation. As the chart shows, one standard deviation covers 68.2% of the data sample (dark blue). Two standard deviations cover 95.4% of the data sample (dark blue + medium blue). And three standard deviations cover 99.6% of the data sample (dark blue + medium blue + light blue).

So what does all this have to do with investment returns?

For investment returns, standard deviation shows how much variation an investor can expect from year to year for a particular asset class. Standard deviation shows how much variation there is from the average. A lower standard deviation represents a less risky investment and a higher standard deviation represents a more risky investment. Let’s look at a couple of examples. Let’s calculate the standard deviation for the last ten years of two assets classes, large cap stocks and short term government bonds.

The average return of the S&P 500 over the last 10 years is just over 1%. The standard deviation for the S&P 500 over the last 10 years is about 21.

So what does this actually mean?

To keep the numbers simple, let’s assume from the table above that the S&P 500 had an average return of 1% and a standard deviation of 20.

This means if you were to invest in the S&P 500 you could expect your return to fall between -9% and +11% about two thirds of the time (this represents one standard deviation). Further, you can expect your return to fall between -19% and +21% ninety-six percent of the time (this represents two standard deviations). And 99.6% of the time, you can expect your return to fall between -29% and 31% (this represents 3 standard deviations).

 

The average return of the 10 year US Treasury Note over the last 10 years is just under 4.5%. The standard deviation for the 10 year note over the last 10 years is under 1.

Again, let’s keep the numbers simple. Let’s assume from the table above that the 10 year US Treasury had an average return of 5% and a standard deviation of 1.

This means if you were to invest in the 10 year note you could expect your return to fall between +4% and +6% about two thirds of the time (this represents one standard deviation). Further, you can expect your return to fall between +3% and +7% ninety six percent of the time (this represents two standard deviations). And 99.6% of the time you can expect your return to fall between +2% and +8% (this represents 3 standard deviations).

When it comes to retirement planning, the ideal investment has the highest return and the lowest standard deviation. A greater focus should be put on the standard deviation, b/c that increases the certainty that your money will last. Unfortunately, most investors focus more on achieving the highest returns without realizing that the relationship between risk and reward is not linear. Attempting to increase your return by 1% per year may double or triple the risk that you run out of money. To a person in retirement with a finite amount of money, this is hardly a risk worth taking. To understand more how risk and reward fit in to retirement planning, click here.

At PIG we believe the right allocation for the money you know you will need is a globally diversified portfolio of 30% stocks and 70% bonds. The 30% stocks give you the edge you need to keep up with or slightly outpace inflation while the 70% bonds give you the stability needed for retirement income. Click here to see the returns and standard deviations of our investment models.

Once you have the amount of money you need invested in a 30/70 portfolio, you can invest your excess monies more aggressively. It is OK to reach for higher returns with your excess monies, but we do not think it is wise to do so with the money you know you need b/c the added uncertainty outweighs the potential benefit of higher returns. We believe the primary retirement goal should be to meet your objectives without running out of money. Introducing the possibility that you run out of money so you can say you had a higher average return seems illogical.