The most important factor in investing yesterday, today, and tomorrow is risk.
What is risk? Is it a mystical and illusive measurement that we can reduce to a number and write it on the back of a napkin? Or is it this all knowing number that will allow you to sleep better at night? Well, Wall Street and mathematicians have been trying the number game for a long time and if you ask them, they’ll tell you that got it all figured out (more on that illusion in a later postt). However, for you, me, and the majority of people risk takes on a pretty simple definition… the permanent loss of capital. A pretty simple phrase with a lot of meaning and emotion to it, huh. Armed with that definition of risk let’s dive in and see how risk is typically measured, the effects of risk on your nest egg, and answer the question at title of this article, “Can a 6% return really beat a 15% return?”
Now how do we measure and control this animal called risk. The simplest (note: simple and easy are not related) way is to manage or control the volatility your investments are exposed to. In its purest form volatility is the level of change / fluctuations in your account value measured in days, months, or years. Volatility is expressed as a percentage. Leaving out the technical details, if your portfolio has an expected annual volatility of 15%, you could expect your account value to fluctuate 15% (plus or minus) from its expected average return. Note, in some circles many people refer to volatility as the ulcer index. And in the following example we’ll see just how that ulcer starts.
The consequence of chasing performance with no regard for volatility (risk). For our first example let’s look at an investor who we’ll call “Mr. Hare”. Now Mr. Hare is in quite a hurry to grow his portfolio so he decides to invest in a high performance mutual fund in a hot sector. The table below shows Mr. Hare’s three year performance. Notice anything odd? Yes, that is correct, mathematically the Hare’s average return was a positive 15%, however, he has $1,000 less than he originally invested. Man, talk about an ulcer.
| Mr. Hare’s 3 Year Performance |
|
|
|
|
|
| Year |
Value |
Return |
|
| 0 |
$10,000 |
|
|
| 1 |
$20,000 |
100% |
|
| 2 |
$20,000 |
0% |
|
| 3 |
$9,000 |
-55% |
|
| Total |
$9,000 |
15% |
|
| |
Loss of $1,000 |
=(100% + 0% + -55%) / 3 = 15% |
|
Let’s take a look at our next investor, who we’ll call Mr. Tortoise. Mr. Tortoise wants his nest egg to grow, but he is uncomfortable with high volatility and skeptical of the hottest fund hyped on MSNBC so he decides to invest in a conservative, boring old mutual fund (a low cost, no-load fund, of course). The table below shows Mr. Tortoise’s three year performance. As you can see Mr. Tortoise’s “mathematical” average return was 6% annually. And his nest egg grew from $10,000 to $12,000, outperforming Mr. Hare’s fund by a net gain of $3,000. Not too shabby.
| Mr. Tortoise’s 3 Year Performance |
|
|
|
|
|
| Year |
Value |
Return |
|
| 0 |
$10,000 |
|
|
| 1 |
$10,800 |
8% |
|
| 2 |
$11,100 |
3% |
|
| 3 |
$12,000 |
8% |
|
| Total |
$12,000 |
6% |
|
| |
Gain of $2,000 |
=(8% + 3 %+ 8%) / 3 = 6% |
|
As you can see higher average returns and higher volatility doesn’t always result with your nest egg growing. Just like the fable about the tortoise and hare, slow and steady wins the race on Wall Street. Chasing returns will almost invariably result in one of those 15% returns with a “permanent loss of $1,000 in capital… OUCH!”
Worth your Weight in Salt?
