It’s been said that risk and reward constitute a double-edged sword, inseparable and ever-present in all aspects of life. We make daily decisions with our health, relationships, time, and more that in some way demonstrate a tradeoff between risk and reward. These decisions, while seemingly trivial at times, are mental calculations that attach probabilities depending on the gravity of each situation.
So how do we calculate the inherent relationship between risk and reward in our investment portfolios? I know financial jargon is dull to most people, but this term’s impact shouldn’t be. It’s called standard deviation, and few investors have a clue as to what it means to their portfolio. (For related reading, see: Financial Concepts: The Risk/Return Tradeoff.)
Standard Deviation and Volatility
First, higher isn’t always better. Double-digit returns feel great. For risk-averse investors, double-digit standard deviation does not! As a historic volatility measurement, think of standard deviation as a thermometer for risk, or better yet, anxiety. The higher it goes, the higher your blood pressure rises during volatile times. Portfolios that report large standard deviation numbers have experienced wide fluctuations in returns, both positively and negatively, around the average return. Those with a lower standard deviation have been able to mitigate volatility, meaning the up-and-down swings of the returns aren’t as wide. (For related reading, see: Where Do Investment Returns Come From?)
How Standard Deviation Works in Practical Application
For this example, we’ll use 2x standard deviation. All that means is we’ll be multiplying the standard deviation by 2 (known as the 95% confidence interval, which basically says that 95% of the time we can expect the return to lie between these two numbers in any given year). From the beginning of 2007 to the end of 2016 the S&P 500 average annual return was 6.95%. The standard deviation was 15.28%. Simplifying the numbers: 15 x 2 = 30. Now we just add 30 to the 6.95% average return to get 36.95% and subtract 30 from 6.95% to get -23.05%. In summation, with 95% confidence, we can expect the S&P 500 return to fall between +36.95% and -23.05% in any given year based on historic volatility over the last 10 years.
Typically, as exposure to assets that tend to fluctuate more (i.e. stocks) increases, so does standard deviation. Therefore, if well diversified, a 100% stock portfolio will likely have higher historic volatility than 80% stocks, 80% higher than 60% stocks and so on. However, it doesn’t stop at the portfolio level. The underlying funds that make up your portfolio also exhibit volatility characteristics based on their makeup, sort of like a portfolio within your portfolio. For instance, you should generally expect an emerging market fund to have a higher standard deviation than a U.S. large-cap growth fund because of the historically high volatility associated with emerging markets as an asset class. Why is that important? All else being equal, two portfolios that appear similar from a general stock-to-bond ratio will likely have vastly different experiences if one has 20% more exposure to emerging markets than the other. (For related reading, see: The Risks of Investing in Emerging Markets.)
Returns should always be discussed in context of the level of risk it took to achieve them. When it comes to measuring volatility, the more years of data the better. Standard deviation shouldn’t be measured over a period of less than three years, with a preference being the inception date of the portfolio or fund. The concept of risk and reward is ever-present in our daily lives. Understanding the true level of risk in our portfolios only serves to reinforce expectations and strengthen the discipline of long-term investors. (For related reading, see: The Anatomy of Exchange-Traded Funds.)