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April 27, 2014

Control risk, don't avoid it

While there are various types of investment risk, the proxy most often used by investment professionals is a statistical measure known as standard deviation. In basic terms, standard deviation indicates how volatile and unreliable the returns of an investment can be. The more volatile the expected returns, the higher the standard deviation and risk because the chance of experiencing a large loss on the investment is greater.

For these reasons bank savings accounts, high quality bonds and stocks have low, moderate and high standard deviations respectively. Because risk and return are correlated, we can expect (but are not assured of) higher returns from stocks than bonds and higher returns from bonds than savings accounts.

In 1952, Harry Markowitz, a Nobel laureate in economics and a pioneer in the area of finance known as modern portfolio theory, proposed that both math and common sense suggest that investors should consider both risk and return when making investment decisions. Furthermore because investors are risk averse, they should demand suitable compensation for taking on risk.

A rational person, therefore, will only invest in riskier securities if they believe that the expected returns on those securities will be high enough to warrant taking on the risk. Otherwise, a prudent investor would choose less risky but equally profitable alternatives.

There are two central and related tenets of modern portfolio theory that have important implications for the everyday investor. First, by mixing different types of stocks that move up and down independently of each other, investors can reduce the volatility of their overall portfolio. This is known as diversification. Markowitz further demonstrated that while diversification reduces portfolio risk it does so while maintaining and potentially enhancing returns. This is why diversification is considered the one “free lunch” in finance. Second, because risk reduction through diversification can be easily achieved, the financial markets do not reward investors who fail to diversify their holdings. The result is what many investment theorists refer to as uncompensated risk.

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