Too often reward takes the front seat. You’ll hear friends bragging about their winning stocks. But it’s important to ask… what risk did they take to get that reward?
This is what sets apart novice and experienced investors. When investing, it’s vital to take – and improve – your measurements of both risk and reward. Because if you take on too much risk, you might not be able to recover.
To put this in perspective, let’s say you put all of your savings in one investment. The example below shows losses followed by the gain you need just to get back to where you started…
|Investment Loss||Gain to Breakeven|
One simple way to manage the risk of a catastrophic loss is to diversify. It’s the proverbial don’t put all of your eggs in one basket. And hopefully you’re already aware of the benefits of diversification. If you’re not, you can check out my video on diversification and why Warren Buffett accepts his ignorance.
Today instead, I want to focus on risk measurement and how timeframe impacts risk. I know… it’s an exciting topic, right? Well, one key takeaway from this article could easily mean the difference of $100,000 – or easily more – in your portfolio down the road.
Managing Risk Starts with Risk Measurement
In the investing world, standard deviation is a common measurement of risk. It’s a statistic that measures the dispersion of a data relative to its mean.
So, the higher the standard deviation, the riskier we can expect the investment to be going forward. And of course, past performance is no guarantee of future returns. There are reversals and on occasion, new normals. Statisticians sometimes call these stationary or regime changes. But in general, the trend is your friend.
In fact, past data and trends are the only things we have to make informed decisions going forward. One key though is looking at more inclusive, less biased datasets and trends over different timeframes.
Now, I don’t want to bore you with statistics jargon. Like what’s the difference with unimodal platykurtic distribution and leptokurtosis (thanks CFA exams). Instead, I want to shed light on risk measurements in general, or more so risk-to-reward measurements. And I think I’ve found a simple, yet powerful way to do that.
Each risk-to-reward measurement or tool has different pros and cons. To measure different investment or portfolio returns, you could use the Sharpe or Sortino Ratio, the Treynor Measure, or many others…
For the most part, the reward side of all of these measurements is the same. It’s usually an average of returns over the timeframe. And on the other hand, the risk side of these equations is what differs the most, due to risk measurement flaws…
Risk Measurement Flaws and Timeframe Management
Using standard deviation alone doesn’t always give the best guidance. There are many assumptions behind it and this example reveals some issues…
Portfolio A has a much lower standard deviation than Portfolio B. So, some risk averse investors might choose portfolio A… but portfolio B has a much higher risk-to-reward ratio. And in most of the years, portfolio B has outperformed by a wider margin.
I hope this helps show why it’s important to use different risk-to-reward measurements. Learning more about risk management can have a huge impact on your portfolio. And now I want to leave you with one final thought…
The general wisdom is that government bonds are safer than stocks. But there’s a big assumption here. And most people overlook it. Government bonds are only safer than stocks in the short-run, not the long-run. That’s an important distinction.
If you have multiple decades before tapping into your investment, like many retirement accounts, it’s riskier not to invest in stocks. That’s assuming you want to maximize your returns, and can have a staggered drawdown period over many years. (Even if you’re retiring soon this can make sense. You’re not going to pull it all out at once).
That’s why after I built up a big emergency fund, I started buying more stocks. I’m hoping to reach an allocation of over 90% stocks in my total portfolio. And outside of collecting dividends, I don’t plan on touching those investments for a few decades.
Sure, it won’t be fun watching the big swings – AKA risk – most years. But I know in the long-term, it has a very high probability of higher returns. And when using more appropriate long-term risk measures, it’ll also have a much better risk-to-reward ratio.