If you're like most people, you evaluate your portfolio in terms of its return.
However, return isn't the only factor you should consider; also important is the amount of risk you take in pursuing those returns. The term "risk" is often understood to mean the risk of loss. However, a portfolio is generally a means to an end, such as paying for retirement or a child's college tuition. In that context, "risk" also means the risk of not meeting your financial needs.
Let's say that Don's portfolio earns an average of 7 percent a year for 10 years. However, his annual returns have been very uneven. One year his return might be 11 percent, another year it might be down 10 percent. Meanwhile, Betty's portfolio also has averaged a 7 percent annual return in the same time, but her returns have been more even. She hasn't had spectacular years, but she has avoided any negative annual returns.
You might think both would end up with the same amount of money after 10 years, but that's not necessarily the case. It depends in part on the timing and size of the declines in Don's portfolio. A big loss in the first year or two means he'll spend valuable time recovering rather than making the most of compounding. That can affect future growth. That's why it's important to consider an investment's risk-adjusted return.
One of the most common measures of volatility is standard deviation, which gauges the degree of an investment's up-and-down moves over a period of time. It shows how much the investment's returns have deviated from time to time from its own average. The higher the standard deviation of an investment or portfolio, the bumpier the road to those returns has been.
The risk of not achieving your goals
Another way to evaluate risk is to estimate the chances of your portfolio failing to meet a desired financial goal. A computer modeling technique known as a Monte Carlo simulation generates multiple scenarios for how a portfolio might perform based on the past returns of the asset classes included in it. Though past performance is no guarantee of future results, such a projection can estimate how close your plan might come to reaching a target amount.
- Betty Wellhoefer Hill is president of Crescendo Wealth Management LLC in Grafton.