You may know about the food pyramid. It tells you to eat more healthy foods, fewer “unhealthy” ones.
There is another pyramid you should know about: the risk pyramid. Its message is that over time, the higher the risk of an investment, the higher the potential return; the lower the risk, the lower the potential return. With the U.S. equities markets closing in on three years negative returns, a lot of attention is being paid to relationships between risk and return.
But measuring risk is not simple. It is probably for this reason that many people don’t measure risk at all, or they miscalculate it and end up disappointed with their investment returns. This is one of many reasons that individual investors often end up selling at market bottoms and buying at market tops.
All the best measures of risk involve the use of historical data. Because we know that history is no guarantee of the future, we must be cautious about using historical data to project the future. But because investments tend to perform in a manner similar to the way they have performed in the past, historical data, can provide a solid base from which to measure risk.
The most useful historical data in measuring risk are rates of return. If we calculate the volatility of these historical rates of return around the average, it’s called standard deviation – a very useful measure of risk.
Are stocks risky? Are bonds less risky than stocks? The answer is “sometimes.” I can show you bonds that are riskier than almost any stock and stocks that are riskier than many bonds.
The key to managing risk is to assemble a portfolio of investments with whose riskiness, or expected volatility, you a comfortable. Your goal should be to buy investments which, together, offer the highest expected return with the lowest possible risk. This is easier said than done.
Access to data is important. There is a free web site (www.riskgrades.com) that uses a variation of standard deviation to calculate a risk grade for equity, mutual fund and foreign investments. Having a risk grade can help you to measure the risk of your current portfolio or assess the risk of an investment you may be considering, relative to the risk of other investments or market benchmarks.
When it comes to personal finance, risk is not just a coin toss anymore. It is quantifiable and measurable. Having access to data and technology can help an investor to make informed decisions about risk.