Nov 18
The Importance of Risk Management
Risk implies we do not know what is going to happen, even though we have an idea of the range of variation or probabilities we face over the near future. There are at least two types of risk we face as investors. There is “systematic” risk that we cannot control. These risks include credit crunches, business activity, inflation, fraud, currency exchange rates, day to day market fluctuations, etc. The second type of risk is one we can control. For example, if an investor chooses to purchase a dozen large-cap growth companies and calls that a portfolio, additional risk is accepted vs. the investor who places all his or her investments in treasuries. We call these decisions, “specific” risk and these can be avoided or at least modified.
Take the portfolio listed below where 50% of the investments are positioned in equities while 50% are allocated to bonds. Note under Portfolio Stats that this portfolio is projected to have a return of 7.7% (rounded) and a projected standard deviation of 12.2% for a Return/Risk ratio of 0.63. Our preference is to see this ratio closer to 0.70, but keep in mind we have not tweaked the asset allocation to come up with this ratio. Also note the Diversification Metric is 26%. Portfolios we create over on Premium Content tend to have DM values closer to 40% or higher. At least that is our goal when we set up a portfolio.
Now move down to the second screen shot to view a portfolio that eliminates bonds.
If we eliminate bonds and double up on the equities and commodities, we push the return up to 10.9%, but we sacrifice that additional return by increasing the risk. The projected Standard Deviation is now 19.9% and that translates into a Return/Risk ratio of 0.55. This is an unacceptable ratio unless one is willing to see a portfolio drop by 40% in a two SD event, such as we experienced in 2008 and early in 2009. Drop down near the bottom of the screen shot and you will see the Diversification Metric for this portfolio dropped to a measly 13%, or far too low for our comfort level.
What we are saying is that an all equity portfolio will not cut it. At least one designed using the ETFs listed below.
Premium subscription available for $6.99 per month. See portfolios with DM above 40% and Risk/Return ratios closer to 0.70.