Lower Your Risk

If 100% of your portfolio was invested in the S&P 500 you would have expected to experience a loss greater than -7.8% (two standard deviations below the mean) in one month 12 times (2.3% times 541 months) over the last 45 plus years or about once every 4 years. Individual companies and some other assets have even higher volatility than the S&P 500. Depending on your risk tolerance this type of risk may be too high.

Risk can be lowered through the selection of lower volatility assets. Bonds typically have lower volatility than stocks. For example, the 10-year US Treasury has a monthly volatility of 2.06% from 12/31/71 through 1/31/17. A portfolio constructed of 10-year US Treasuries would have less than half the volatility of the S&P 500 portfolio. Of course the drawback is that lower volatility assets typically have lower returns than higher volatility assets.

Risk can also be lowered through diversification. Investing in multiple uncorrelated assets lowers volatility without sacrificing returns (see blog post: The Importance of Correlation). For example, the S&P 500 and 10-year US Treasuries have a low correlation coefficient of 0.11(*). A portfolio with 50% in each asset has a volatility of 2.52%. This is significantly lower than the 3.22% average of the individual volatilities which shows the power of diversification.

* Correlation coefficient measures the correlation between two sets of data. A correlation coefficient of 1.0 implies that the two sets of data are perfectly correlated. A correlation coefficient of 0.0 implies the two data sets are uncorrelated. A negative correlation coefficient implies a negative correlation between the two sets of data, they tend to move opposite to each other.

 

Disclosure:

The information presented here is the opinion of the author and may quickly become outdated and is subject to change without notice. All material presented in this article are compiled from sources believed to be reliable, however accuracy cannot be guaranteed. No person should make an investment decision in reliance on the information presented here.

The information presented here is distributed for education purposes only and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or participate in any particular trading strategy.

Performance data showing past performance results is no guarantee of future returns.

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