How to Measure Investment Risk & Protect Against it
Investing is Risky
The Investments class I teach at a local university focuses on investing risk and return. We talk about the risk that you’ll lose money if you invest and your stock and bond funds decline in price. There’s also the risk that your purchasing power will erode from inflation. According to a recent Fortune-CNN article food prices increased 2.6% last year. Although, in my region, it seems as though the food increases were quite a bit more. Although the CPI (consumer price index) reported a seasonally adjusted increase of 1.7%, your personal inflation rate varies based upon the region where you live and what you buy.
So how do you measure investment risk and protect yourself?
What is Investment Risk?
Standard deviation measures how much your investment returns deviate from the average. In reality, investors care about the negative returns, not if you have a year with exceptionally high investment returns. Investors measure risk by the percent their investment portfolio drops in value.
Here’s how to measure your portfolio returns. Mathematically, find the difference between the beginning and ending value of your portfolio. Next, divide the results by the beginning value of your investments. For example, if your portfolio was worth $10,000 on January 1 and on December 30 of the same year it’s value was $9,000, you lost 10%. That’s an example of investment risk, and how to calculate.
$9,000 – $10,000/$10,000 = -10%
Systematic or Market Risk
Market or systematic risk is unavoidable. A natural disaster will trounce investment returns across the board. Systematic risk also includes the cyclical recessions that hurt all market returns. You cannot avoid market risk.
Unsystematic or Firm Specific Risk
Firm specific or unsystematic risk applies to an individual firm. When Lehman Brothers experiences an accounting scandal or misses earnings, the stock price falls. This firm specific risk only impacts an individual company, not the entire market. This risk can be diversified away.
Hold a broadly diversified portfolio and firm specific risk is eliminated.
Protect Your Portfolio Against Investment Risk
Investment markets and the economy are cyclical. There are cyclical booms and busts in both.
Since no one can predict the future, you need to expect that at one time or another, your investments are going to drop in value. If you can’t handle any volatility in your investment prices, then it’s best to remain in Government I bonds and cash investments. With inflation protected securities like TIPs and I Bonds, you’ll protect your portfolio against inflationary loss of purchasing power.
Stocks and bonds typically offer higher returns than cash or Treasury I bond returns. But, with that promise of higher returns comes the cost of portfolio volatility.
If you are interested in the higher returns that stocks and bonds offer and can accept a bit of volatility in your asset values, here’s how to minimize that risk. All investments do not move up and down in tandem. At times, stock prices fall and bond prices rise and vice versa. At times U.S. stock prices rise and European stock prices fall. Diversification is the only way to protect your investments from extreme volatility.
Diversification Protects Against Firm Specific Risk
Place your investments in a diversified mix of stock and bond mutual funds. Keep these assets internationally diversified. That way, when the U.S. stock market falls 10%, your bond investments may rise a bit and offset the drop in price. You cannot completely eliminate investment risk and inflation risk, except through investing in Treasury Inflation Bonds. Yet, the problem with those investments is that their returns are usually lower than a more risky diversified portfolio of stock and bond index funds.
Consider a broadly diversified portfolio to eliminate firm specific risk.
Diversification will not eliminate declines in the value of your investment portfolio. Diversification makes those ups and downs in returns a bit less dramatic. If the U.S. stock market drops 20% one year, because you hold international stocks and bonds, your portfolio will fall less than 20%. Conversely, when stocks go up 20%, your portfolio will go up less than 20%. When stock and bond prices are less correlated, portfolio volatility is reduced and you still benefit from market increases and suffer less from market declines.
There are many strategies that promise high returns with little risk. The tried and true method of diversification with index funds is tough to beat over the long term.
How easy do you think it is to predict investment returns? Do you think there are folks who’ve experienced market beating returns over many years?
A version of this article was previously published.