It’s the forecasting and evaluation of financial risks together with the identification of procedures to avoid or minimize their impact. Thus and in theory, I can use it to benefit from the upside of assets with more risk (potentially more return). While managing the downside for the overall portfolio (not getting wiped out in the process).
In practice, not that simple.
Not taking risks one doesn’t understand is often the best form of risk management.
― Raghuram G. Rajan
One of the key definitions used in finance and investing is risk-return. The theory says that if you take more risk, you will potentially have more return. On the other hand, low levels of uncertainty or risk are associated with low potential returns.
This definition implies that invested money can render higher profits only if the investor is willing to accept the possibility of losses.
History has proven that for long periods of time this is true.
If you watch the Annual Returns on Stock, T.Bonds and T.Bills (1928 – Current) you will get the idea. Investing $100 in 1928 will have the following compound return:
Treasury Bonds: $7,309.87
Treasury Bills: $2,015.63
If I invest more money in stocks, I get paid a higher return for holding that risky asset. Common sense right?
Well no. I mean yes. In fact…it depends.
If you compare the last 3 years of two assets: the SPY and VWO, they will tell you a very different story.
SPY – SPDR S&P 500 Index
VWO – Vanguard FTSE Emerging Markets
VWO tracks stocks from Emerging Markets. In theory, this is a riskier asset than stocks from the biggest companies in the US. Companies that are among the most stable and with less volatility associated than in other regions in the world.
So you should get a higher return to withstand the superior volatility of emerging markets, right?
More risk not exactly equal to more return
As you can see in the above image, the VWO with more volatility (18.9%) didn’t deliver more return. In fact, the return was less than 50% of the SPY.
You have to go back more than 10 years to see a period of +3 years where the Emerging Markets far outperform the SPY. Total Return (including all dividends) from Mar 04, 2005 – Jun 30, 2008, was:
VWO – 95.3% with a 26.9% volatility.
SPY – 11.2% with a 13.9% volatility.
How to Know When to Risk More
The message is clear:
If I have long time horizons, and more tolerance to the volatility associated, I should increase the portion of the portfolio with more risk. If not, decrease.
I have no doubt in my mind that emerging markets will reign again. The only problem is that it can be “tomorrow” or in ten years from now. No one knows. Hence the utility of having a portfolio with a diversified basket of assets (e.g. stocks and bonds) and rebalance in an appropriate frequency. For example, once a year. Plain and simple.
Another Strategy to Deal with Risk
If an investor is looking for a long-term plan here’s an option: Start early and with a strong allocation to stocks, and then decrease that allocation throughout your life. The bonds part of the portfolio goes in the opposite direction: starts with a small portion of your money then increases until is the majority of the portfolio.
Giving you peace and stability when you most need it: Retirement phase.
If something isn’t clear, please do tell me so I can explain in more detail (or correct). Remember this is only for information purposes. This is NOT advice of any kind. Seek professional help if you need. Read the disclaimer.