How You Manage Risk Affects Your Rate of Return

Most people are afraid of the market. When the market goes whacky, it is time to pull your chips off of the table and wait out the storm. Yet, historical evidence shows that those who stay invested in a properly managed and diversified portfolio will be better off in the long run.

So risk (volatility) really determines results. If you have no tolerance for risk, then you would choose to put your money in treasury bills, as an example. But in reality you have traded one risk for another. You have traded capital risk for purchasing power risk. Treasury bills have had a negative return over the last 50 years if you factor in taxes and inflation.

So to beat inflation you must take risk. We say – “You purchase return by buying risk.” This means that the ONLY way you will get a decent return on your portfolio is to assume some risk. Risk and return are positively correlated. You can’t have one without the other.

Tall GaussianIf you look at these two charts you will see one is tall and narrow and the other is wide and short. Both charts depict a concept called standard deviation.

 

Standard deviation is how we measure volatility. Assume we have 20 measurable events over a period of years. If you added them up and divided by 20 you would have the average. But what is volatility? Assume each event was 10%. Then there would be no volatility because each one was 10%. But if 10 were 5% and 10 were 15% – you would have a volatility of +/- 5. You would still have the same average of 10%; but the events would be either +5% or -5%.

Low Volatility Investment
Portfolio A
Year Return Amount Invested
$100,000
1 10.00% $110,000
2 10.00% $121,000
3 10.00% $133,100
4 10.00% $146,410
5 10.00% $161,051
Average: 10.00%
IRR: 10.00%

 

The larger the variance, the more volatility. So the ideal portfolio would have a high average but a low variance. Here are two examples. Portfolio A earned 10% every year for 5 years. The average was 10% and the time weighted return (called Internal Rate of Return or IRR) was 10%. If you drew a standard deviation chart it would be a straight line – because all of the events would be the mean (the average).

Now let’s look at 5 events that are more varied in Portfolio B. The average is still 10%, but if we calculate the IRR, it is 9.03%. Almost a full 1% lower than the Portfolio A. The average was the same, but the results were different.

High Volatility Investment
Portfolio B
Year Return Amount Invested
$100,000
1 0.00% $100,000
2 15.00% $115,000
3 10.00% $126,500
4 5.00% $132,825
5 20.00% $159,390
Average: 10.00%
IRR: 9.77%

So if you had invested $100,000 in Portfolio A, you would have $161,051. But in Portfolio B, you would only have $159,390. The difference $1,661 is attributed to risk, volatility.

The Wealth Teams portfolios are designed to minimize the volatility. To bring the returns closer to the average and avoid the wide swings. We know historically, this will improve performance and also provide fewer beads of sweat when the market goes wild.

If you would like to compare the risk – reward price tag of your portfolio to a Wealth Teams portfolio, fill out the risk tolerance questionnaire and we will score it and let you know how you would do with a portfolio that matches your comfort level.

Want more education? Purchase one of Guy's Books

Read more about Guy: Click here