Defining Portfolio Risk

There are as many ways to view risk as there are investors.  We simpletons tend to define risk in terms of “I lost money.”  Such a loss is relative and can be compared to a benchmark’s return, our own historical return, a number of dollars lost on a particular investment, or our ultimate financial goals.  Finance professors tend to define risk in terms of volatility (of either price or returns) over a given period.  Volatility can be measured in different ways over different periods, so we must be careful to note exactly what we are considering when we hear someone else talking about volatility.  When we are considering our entire portfolio, we usually consider volatility with respect to our return.  If our return is highly volatile, it means that the returns are very erratic.  Low volatility, on the other hand, means consistent investment returns.

Given what we have said about the relationship between risk and reward, you would expect an investment with high volatility to yield a high return.  This is a logical fallacy.  High volatility does not necessarily predict a high positive return.  In other words, you will not always be rewarded for taking risks.  Volatility spikes when a security’s price takes a nosedive, and you are definitely not making any money under such circumstances.  You must carefully construct your portfolio such that you are usually rewarded for taking risks.

When the economy is losing steam and markets start to tank, correlations tend to converge, and all assets can plummet in what can seem to be perfect unison.  What this means is that no portfolio asset allocation strategy can prevent all losses.  It can prevent many down days, and it can provide brakes that keep a disaster from being a catastrophe.  Asset allocation is not, however, a magic formula for eliminating risk.  The fact that we cannot eliminate risk is why finance professionals talk about risk management instead of risk elimination.

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Last Updated: 6/25/2018