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How to Measure Investment Risk & Protect Against it

By in Advanced Investing, Asset Allocation, Bond, Economics, Investing, Stocks | 9 comments

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?

Investment risk-no risk-no reward. How to protect against investment risk.

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.

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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.

Minimize investment risk with diversification!

 

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.

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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.

    9 Comments

  1. Bernie Madoff had returns that consistently beat the market and we saw where that went! Nice explanation. I to limit volatility in my portfolio through diversification in many ways. I have a combination of mutual funds, stocks and bonds that reduce some of the volatility. At this stage of my life, I want reasonable growth and very little losses. So far so good!

    krantcents

    February 10, 2013

  2. Yes – spread your risk by diversification.

    But risk is not additive. If something goes up by 10% then down by 10% then it is actually 1% down overall (1.1*0.9 = 0.99). This doesn’t matter for small changes but it does for large changes – up by 50% then down by 50% means you are 25% down overall (1.5*.5 = 0.75). So beware!

    John@MoneyPrinciple

    February 10, 2013

  3. @Krantc-As the saying goes, “if it sounds too good to be true,” it probably is. Out sized returns come with a price tag.

    BARBARA FRIEDBERG

    February 11, 2013

  4. Hasn’t Warren Buffett had returns consistently in excess of the market?

    One of the beefs he has with finance academics is the definition of risk. In the finance literature, risk is pretty much equated with volatility. That may work for academic studies, but Buffett thinks that’s absurd. To him, upward volatility is good; only the downward volatility is bad.

    Because of that philosophy I’ve (a) consistently attempted to NOT diversify away the upside potential, and so I never have more than 4 or 5 stocks in my portfolio.

    (b) consistently sought out high beta stocks since 2009. The thinking behind that is that in a cyclical uptrend higher beta stocks will outperform the market.

    There’s no promise that the future will be as good as the past, and I know that, but so far this strategy has significantly outperformed the market.

    William @ Drop Dead Money

    February 12, 2013

  5. Popular radio host Ric Edelman talks about an advisor who could call the market. He sent letters to 1000 people telling half to buy Coke and half to sell. A few weeks later, finding that Coke had gone up, he sent a letter to the 500 who he’d sent the buy recommendation and wrote “I can’t believe you missed that opportunity!” I’ll give you another. 250 he recommended they buy Microsoft, the other 250 he recommended they sell. When MSFT when south, he wrote a few weeks later to the 250, “I’m two for two…when are you going to listen?”

    That guy knows how to call the market…or how to call a sucker.

    AverageJoe

    February 12, 2013

  6. @William, You are not alone. In spite of the research in support of the “efficient market hypothesis” many investors still attempt to beat the market. By taking on more risk and/or being lucky. There are also market anomalies which can lead to out performance. Thanks for weighing in.
    @Joe-That is great. I love that story!

    Barb

    February 12, 2013

  7. I really don’t think there’s a way to accurately predict returns over a long period of time. Sure, anyone can have a bout of luck but what happens when that luck runs dry?

    The Happy Homeowner

    February 12, 2013

  8. I believe in insurance, it will protect you from any risk or uncertainty. However, if you want to lessen the impact of loss or risk, you have to do what others billionaires are doing, diversification. Diversification is the best way to spread out your income as well as the risk.

    My Wealth Desire

    February 13, 2013

  9. The Happy Homeowner, You are on the mark with that comment. Sooner or later, an active investor will under perform the markets.
    @My wealth, Insurance is great, but you need to factor in the cost. Some insurance cost outweigh the benefits. Diversification is the best way to reduce portfolio ups and downs, even though you may be sacrificing some upside potential! Thanks for stopping by.

    BARBARA FRIEDBERG

    February 13, 2013

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