Conclusions (4.2)

When we use volatility as a measure of risk, we can do some very cool things to reduce the risk and maximize the return of our portfolios.  The once impenetrable math has been replaced by web-based software that we can use for free to get the benefits that once were used only by the best-funded portfolio managers.  Investments that are allocated based on reducing variance are also limited to some degree on the returns that they will make.  The idea is not to produce the best returns possible; it is to earn the highest returns possible within a given spectrum of volatility.  Note that the upside of stock moves (prices rises) also count as volatility.  High beta stocks can lose big, but they can gain big as well.  Protecting yourself from the downturns also protects you from the upturns to some degree.

One solution is to forget all of this volatility and portfolio theory stuff and buy the market.  This may well be the ideal situation for a fearless young person just starting a career.  The key consideration here is the psychology of the thing.  Can you pass the sleep test with an all-equity portfolio?  When we get older, and retirement is looming, we must take care that downturns do not cross over into the time in which we need our investment money to live.

History teaches us that some market contractions are relatively small in the grand scheme of things and recovery is rapid.  There are some, however, that take decades to get over.  At some stage in life, you need to think about how much risk you can take in terms of lost buying power rather than your risk preferences.  As that time approaches, you need to bring down the equity stake in your portfolio such that you can weather a massive bear market.


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