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  • Chris Cyndecki CFA, CFP®

Investment Risk

In the investment world, many practitioners quantify investment risk using measures of volatility. The unit typically used is standard deviation, represented as Greek letter sigma: σ. What is standard deviation? Standard deviation is a measure of dispersion around a mean (average value), calculated as the square root of variance. The easiest way to explain the concept is through an illustration and an example. The bell curve below portrays the probabilities representing observed outcomes 1 and 2 standard deviations from the mean.

For example: asset class XYZ had a 10-year average historical return of 7% and a standard deviation (σ) of 5%. This means that about 68.2% of the time, XYZ’s return fell between 2% and 12% (7%±5%) and about 95.4% of the time, XYZ’s return fell between -3% and 17% (7%±5%*2) over that sample period.

The higher the σ, the higher the risk (as defined by volatility). An asset class with a historical σ of 10% should have less predictable returns than an asset class with a historical σ of 3%. Standard Deviation of Asset Classes Using monthly data from 1978 to 2003, Morningstar has created a chart of 14 asset classes, listing their respective arithmetic returns and standard deviations over the period.

Souce: Diversification By combining asset that behave dissimilarly into a portfolio, diversification benefits can be achieved; the standard deviation of a portfolio (risk as defined by volatility) can be reduced by combining asset classes that are less than perfectly correlated. Harry Markowitz won the Nobel Prize in 1952 for his work related to these concepts. What does this mean for your portfolio? By combining assets classes in certain proportions within a portfolio, one can achieve maximum diversification benefits (minimize risk as defined by volatility) for a given level of expected return. This is known as the efficient frontier. Conclusion Creating the optimal asset allocation involves many factors including: taking advantage of diversification benefits, analyzing current economic conditions, and evaluating the subject’s: investment goals, risk tolerance, investment experience, time horizons, cash flow, and constraints. This is where a financial planning and portfolio management team can assist.

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