The definition of investment risk is the standard deviation or volatility of returns around a mean or average. Normally the lower the portfolio volatility, the more consistent the investment returns are. It should be the objective of most investors to maximize your investment returns within an acceptable risk tolerance.
Simply focusing on absolute returns over the longer term, without addressing how much risk you take on, will ultimately prove disastrous. It really should not surprise you that many mutual fund and ETF portfolio managers’ annual bonuses are calculated only on their one- year absolute returns. In my opinion this is absolutely ridiculous as it encourages them to take on maximum risk all the time. Retail investors managing their own monies cannot afford to manage their capital in this manner. On the other hand, pension portfolio managers receive their annual bonuses based on their longer- term performance. This makes much more sense to me and forces pension managers to assess the amount of risk assumed at all times.
There are all types of risks investors face every day. Below I have summarized some of these risks:
How does an investor minimize the above risks? Diversification is the single best way to control the amount of risk assumed. It is important to diversify by asset class, by equity sector, by individual security, by currency and country and by investment style- value, growth and defensive. It is also critical when purchasing individual corporate bonds to properly diversify away the risk associated with one bond.
Many of you may have heard the term Risk Adjusted Rate of Return. It is simply the absolute return from your investments less the amount of portfolio volatility or risk assumed. This concept is a very important one in institutional portfolio management in that it takes into account the risk assumed in measuring how one portfolio manager performs relative to another.
I have seen many retail investors boast about their investment returns without even mentioning the type of risk assumed. My former neighbour told me several years ago what a brilliant investor her son was for speculating and winning big in a cannabis stock. I decided not to tell her that her son was just lucky and did not exhibit any long- term disciplined portfolio management skills. Even if I had told her, I doubt she would have believed me. Making a lot of money by speculating on one stock is not a reflection of how smart you are. It is simply an indication of luck and your desire to take on a lot of risk. The best investors are the ones that consistently achieve solid results year after year without taking on too much portfolio volatility.
While stock picking remains an essential component in achieving solid investment returns, minimizing your portfolio volatility will materially improve the consistency of your returns. Make a lot of small bets in your investment choices instead of a few large ones. As Stephen Jarislowsky, one of our country’s best money managers frequently says, it takes time and patience to achieve investment success. He is implying that it does not pay in the long run to speculate and take on too much risk.