What Does Risk Mean to You?

Believe it or not, one of the hardest concepts for us to make sure clients really understand is that of risk. Most people take it for granted. Intrinsically they have a sense of knowing when something is risky and when it is safe, but often times these are simply perceptions formed through personal experiences or hearsay. As financial planners, we sometimes have a different perception of risk than clients and we work diligently to frame risk in such a way that it is relatable. When it comes to retirement planning, risk to us means running out of money.

Most people relate risk to how much their portfolio fluctuates over time and they tend to fall on opposite extremes, either wanting no fluctuations whatsoever or throwing caution to the wind (unknowingly in most cases). The rate of return is not the only thing that contributes to the growth of your portfolio. The amount of fluctuation, both up and down, has an effect also.

Can it be measured?

Technically speaking, the amount of fluctuation (or risk) is measured by what statisticians call standard deviation or the range of outcomes around an average. It basically reflects the high and low points for most outcomes around an average. When it comes to investing, we can use this measure to get a sense of how much fluctuation an investment will typically experience over time. A high standard deviation will mean more fluctuations. Knowing this measurement helps us choose between similar investments, or help us direct clients between different portfolio allocations. 

How does it work?

Let’s say you have an investment that has averaged a return of 10% over the past ten years with a standard deviation of 15. This means that during that ten year period, most of the annual returns have ranged between -5% and +25%. That is a wide range! There were some really good years and some not so good years, but on average the return was 10%.

What if you had the option of earning a similar return with less fluctuation? Would you be interested? Let’s say investment option B had the same average return of 10% over the past ten years, but had a lower standard deviation of 10. The annual returns ranged between 0 and 20%. Not only would you have experienced less fluctuation, but you would have ended up with more money – even though you had the same average return. Starting with $100,000 ten years ago, investment A ends with a value of $236,139 while investment B ends with $248,832.

Why is this important?

With expected returns being equal, the option with the smaller fluctuation is better. Lower fluctuations lead to better outcomes. For starters, the less a portfolio fluctuates, the better clients typically behave and not make bad emotional decisions. Second, less fluctuation leads to more consistency in performance. Both of these contribute to more wealth being accumulated, which ultimately culminates with a lower risk of running out of it during retirement.

This article addresses one specific type of risk involved in investing. Investing also involves additional risks and investors should always seek specific financial advice based on their own personal circumstances before acting.