Risk and Return

Millions of people invest in in diverse portfolios, but do they understand the difference of risk and return. Many want better portfolio performance with less risk, but is it possible? Yes, it is, but it also depends on how we measure risk and return.

Of the two, return is the easily measured. We calculate the average annualized return over multiyear/rolling time periods. You can see the growth and it is represented by a growth of $10,000 over various timeframes.

If we look at a diversified seven-asset portfolio consisting of US stock, small-cap US stock, non-US stock, real estate, commodities, US bonds and cash all held in equal 14.29% allocations, then the client can expect a 46-year average annualized return of 9.78% if they rebalance as needed. This is safe and the client can reap the rewards in retirement, but what are the other options.

There is the large-cap US stock (the S&P 500) investment. In the same 46-year period where the portfolio consisted of mainly large-cap US stocks, the return investment was higher than the broadly diverse model that included almost 30% fixed income.

While the returns over the long run are significant, many clients have a short term mind set. They expect to make millions in just a few short years, but when comparing an all-stock model to a diversified model the gap shrinks considerably making the diversified model more appealing.

Now what about risk? Risk is a bit trickier to measure. It is complicated and messy. The traditional method is to calculate the standard deviation of return of investment. For many clients is does not mean anything. Some may know that a higher deviation is preferred, but beyond that it means nothing. They only way to make the number useful is by comparison.