One way to help preserve capital and limit losses is to manage the risk within a portfolio. If risk is left unchecked, portfolio values can swing unexpectedly, which can lead to emotional investment decision making. This was evident in March 2009 when many investors sold out as the market was reaching new lows. However, if risk is managed properly, the unexpected swings in portfolio values are minimized and therefore, rational decision-making can take place.
One common measure of financial risk is standard deviation. For the purpose of this discussion the important thing to know about standard deviation is that the higher the standard deviation the higher the volatility. Reducing the volatility of a portfolio reduces the potential up and down swings in an investment portfolio. At RGB Capital Group, we strive to minimize these types of swings.
The standard deviation of the major indexes over a 20 year time horizon (see figure below) gives you an idea of the trade-off between additional risk and return. In general terms, there is a relationship between risk and reward…the higher the risk the higher the annualized return. Would a rational investor want to move up and to the left on this chart to achieve better risk-adjusted returns?
Figure: Market Risk vs. Annualized Return
(20 years - 9/28/1989 to 9/28/2009)
Ask yourself these questions:
1) If you had the option of two investments, each providing a 7% return, however one of those investment options was half as volatile as the other, would you prefer the less volatile option?
2) If you had two investment options each with the same level of volatility but one provided a higher return, would you prefer the one with the higher return?
If you answered 'yes' to either or both of these questions, you are someone who is seeking less volatility by being in the upper, left side of the chart above. RGB Capital Group attempts to keep clients in the upper, left-side of this chart by providing better risk-adjusted returns.