Portfolio Return and Volatility

 

Recall from our earlier discussion that the average yearly return of an investment can be a serious overestimation of how well an investment performed and that most investors choose to look at the compound return for this reason.  Another problem with portfolio returns is how your investment company factors in your current contributions.  If your metric is the balance increase over time, then your portfolio returns and your contributions for the period are factored in.  The amount of change due to your contributions will drop as a percentage the longer you invest and the larger your portfolio has become.  You may have to dig deep into the footnotes and fine print to determine how your investments are actually doing.

Risk for the professional portfolio manager is the standard deviation.  Commonly, we can examine the relationship between standard deviation and return by graphing it such that standard deviation is on the horizontal axis.  The standard deviation cannot go below zero so the risk element can range from zero to infinity.  By way of comparison, cash has no standard deviation (in practical terms), so when we graph it, the dot falls on the return line (vertical axis).  A coin flip has an expected return of zero, and a very high standard deviation (about 100%).


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