Risk — the possibility of losing money — is one of the most feared words in investing. Despite most people’s aversion to risk, the history of market manias shows that most people — even some of the most risk-averse — have the ability to abandon their fear of losses when asset prices soar for a long time and everybody else seems to have made a lot of money. So, what gives some people the ability to control their emotions and make cool and calm decisions? Two main reasons are that they know how to measure and how to manage risk. And, to the extent that individual investors learn both, they increase their chances for making smart decisions that keep their portfolios on track toward meeting their goals.
Two Ways of Measuring Risk Beta
Professionals have two common ways to measure risk. The first is beta, which is how closely a portfolio’s performance matches or varies from that of a benchmark index. The benchmark for large company U.S.-traded stocks is the S&P 500 Index, while a general benchmark for bonds of medium range maturity is the Barclays Aggregate Bond Index. The performance of indices is normally expressed as a percentage and reflects their total return, which is a combination of any interest or dividend payments and their change in price.
Beta is expressed as a number on an open-ended scale, and it can be a positive number, a negative number, or zero. A beta of 1.0 means that a stock or portfolio’s returns are identical in both size and direction to the benchmark, while a beta of -2.0 means that the portfolio’s returns are twice as large in the opposite direction of the index. For example, when the S&P 500 return is 12%, a portfolio with a beta of 1.0 should also return 12%, while a stock with a beta of -2.0 should lose 24%. A beta of 0.0 means there is no patterned relationship between the two returns.
Standard deviation — A second way professionals measure investment risk is with standard deviation. Expressed as a percentage, it reflects a range of returns above and below an annual average rate of return for the stock or portfolio itself without reference to a benchmark. It’s standard deviation that measures the way many define risk: volatility. In statistics, when applied to investment returns, one standard deviation covers about two-thirds of all returns. So, a portfolio that has an average rate of return of 9% and a standard deviation of 12% means that in six to seven years out of 10, the portfolio’s returns range between -3% and 21%. In general, a lower standard deviation is better, because it reflects less chance of a negative return.
Techniques to Manage Risk Individual investors can use several methods to help reduce the risk and volatility in their portfolios. These include:
- Diversification. The fewer number of securities you own in your portfolio, the greater the risk one or more will produce losses that reduce your ability to generate positive compound returns. In a stock portfolio, that means owning stocks of at least 10 different companies from at least five different sectors (such as, but not limited to, technology, consumer staples, finance, energy, and basic materials).
- Asset allocation. This refers to spreading your investments over the three classic asset classes (stocks, bonds, and cash) according to a formula that potentially matches the rate of return you need to meet your goals. The formula determines what percentage of your holdings should be from each asset class (e.g., 70% stocks, 25% bonds, and 5% cash). Because bonds and cash generate more steady (but smaller) average returns than stocks, the more of each included in your portfolio, the less volatile your overall returns should be.
- Dollar cost averaging. This is a technique that uses price declines to your advantage. It involves making periodic purchases in the same dollar amount of the same securities in good markets and bad. When you continue to buy shares when their prices fall, you buy more shares than when the prices are higher. This gives you more shares, which increases your dollar gains when prices start going back up. However, it neither guarantees a profit nor protects against loss in a prolonged declining market. Because dollar cost averaging involves continuous investment regardless of fluctuating price levels, investors should carefully consider their financial ability to continue investment through periods of low prices.
- Portfolio rebalancing. This is a two-step process by which you restore your holdings to the proportions defined by your asset allocation strategy. The first step is to sell a portion of the investments in those asset classes where your holdings have grown to be larger than their prescribed percentage. The second step is to use the sale proceeds to buy more of the securities from those asset classes whose proportions have become too small. This provides a benefit similar to that obtained by dollar cost averaging. Managing risk isn’t about avoiding all losses, since they are an inevitable and normal part of the investment process. Instead, it’s about minimizing your losses while achieving the rate of return you need to reach your financial goals.
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