Why does risk matter? First, risk can be seen as the level of certainty, or uncertainty, that you will achieve a specific return over a period of time. When moving toward retirement, common sense tells you that you should increase the level of predictability in your portfolio.
Does higher risk equate to higher returns? To answer the question, allow me to share a simple example that illustrates why risk matters. Pretend you have two sisters, Jennifer and Michele, and they each have an investment portfolio. The two sisters invest differently from each other. Jennifer has heard of the saying, “you’ve got to take big risks to get big returns”. By looking at her portfolio, she is up 60 percent in the first year, and down 40 percent in the second year. Add this up and we find that Jennifer has a positive return of 20 percent, which equates to a positive return of 10 percent per year.
In contrast to her sister, Michele’s portfolio contains less risk than her sister’s and she is only up 30 percent in the first year and then down 10 percent in the second year. Add this up, and we find that she has a positive return of 20 percent, which is also a positive return of 10 percent per year. As a result, both portfolios earned a 10 percent average annual rate of return.
Let’s pretend that each sister has one million dollars. In year one, Jennifer earned 60 percent, which is a gain of $600,000. At the end of year one, she has $1.6 million. In year two, she is down 40%, which is a loss of $640,000. At the end of year two, she has $960,000. As a result, Jennifer averaged a 10% average rate of return, but she lost $40,000.
Michele, on the other hand, earned 30 percent in year one, which is an increase of $300,000. At the end of the first year, she has $1.3 million. In the second year, Michele is down 10%, for a loss of $130,000. At the end of the second year, she has $1,170,000. Michele also averaged a 10% average rate of return, yet she is up $170,000.
In summary, both portfolios averaged the exact same rate of return, yet the first portfolio lost $40,000, while the other gained $170,000. How is this possible? Simple, lower risk leads to more money. Bottom line, when you compare two portfolios with the same average return, the one with lower risk will always lead to higher returns. It’s just simple math.
Just imagine if Jennifer and Michele were close to retirement. How do you think Jennifer’s outlook would change, both financially and emotionally? Recognizing how the risk you take affects the growth of your money is absolutely critical, especially if your goal is to maximize your returns while minimizing your risk. Once you understand this very basic truth, your mission becomes clear. Focus on creating the lowest risk portfolio, or lowest volatility, for the rate of return you want to earn.
But here’s the problem. In my experience, odds are you have a pretty good idea as to how much you are earning, but you don’t know how much risk you are taking to earn that return. And if you don’t know how much risk you are taking, then how on earth do you know if you are being properly rewarded for that risk? As we just learned, this is an inferior way to accomplish your goal of maximizing returns while minimizing risk.