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Risk Vs. Reward

I’m going to ask you to pick a portfolio for investing:

  • Portfolio A had an average rate of return of 10% per year over 30 years.
  • Portfolio B had an average rate of return of 8.5% per year over 30 years.

Which one did you choose?

Did you select portfolio A due to its higher average rate of return, or did you select portfolio B because you assumed it was a trick question? Well, in either case, you were wrong.

Well, it was a trick question.

First, you can’t buy past performance, and that means it doesn’t matter what either portfolio did because you didn’t buy it 30 years ago.

Second, I know you’ve heard the old saying that past performance is not indicative of future returns, so you wouldn’t select a portfolio solely based on past performance because that would be a fool’s errand.

And finally, you can’t select the right portfolio because I hadn’t told you whether you were going to invest in a lump sum or over time. And yes, it matters.

So, what the heck am I getting at?

I’m talking about the “risk” of the two portfolios.

Risk is one of those words that gets used a lot when we discuss investments, but it doesn’t always get used the same way which lends itself to misinterpretation.

What I’m referring to when I discuss the risk of a portfolio is the amount of variability there is in the returns – not whether or not you can lose money.

Specifically, I’m talking about the variability of returns around the long-term average – this term is often called volatility and one of the ways that it is calculated is standard deviation. Don’t worry, I’m not going to run through that math here.

The point is that the more volatility there is in a portfolio, the more important your investment strategy is in portfolio selection.

You see, all things being equal, if you are investing in a lump sum, you would want to lean towards selecting a portfolio that has a lower volatility. On the other hand, if you are investing over time, volatility can be an ally. This is because the more volatile the investment, the more opportunities you have to invest at lower prices through dollar cost averaging.

So, let’s go back to the initial question. Portfolio A did indeed have a higher average rate of return, but the standard deviation of that portfolio was also much higher than portfolio B.

This means that portfolio B would have resulted in a better outcome than portfolio A for the lump sum investor – the lower, but steadier returns won out.

On the other hand, portfolio A was the winner when the money was invested over a 30-year time period as the volatility allowed for purchases at a lower cost.

The lesson? Well, that’s kind of a trick question too!

If past performance is not indicative of future results, why would we assume that the standard deviation of either portfolio is going to be the same going forward? We shouldn’t.

When it comes to investments, there is no such thing as a “standard” deviation.

The reality is that the world is constantly changing, and things will happen in the future that have never happened in the past.

The real lesson is that when it comes to investing, it isn’t “set it and forget it”.

Things can and will change over your investing life. You need to make sure that your portfolio keeps up with your goals and your investing strategy.

If you need help in evaluating whether your portfolio is still working for you the way it needs to, get back to personal and sit down with a licensed investment professional (preferably one obligated to act in your best interest) who can help make sure you are on track. And if you don’t have one, I’d be happy to help.

Nothing presented in this piece should be considered investment advice.

The example portfolios presented are hypothetical and not actual portfolios. Past performance is not indicative of future returns.

Dollar cost averaging does not ensure a profit and does not protect against loss in declining markets. It involves continuous investing regardless of fluctuating price levels. Investors should consider their ability to continue investing through periods of fluctuating market conditions.

Do your own research and speak with a qualified licensed financial professional before making any investment decisions.

Investment advice offered through Stratos Wealth Advisors, LLC, a registered investment advisor. Stratos Wealth Advisors, LLC and Wozny Capital Advisors, LLC are separate entities.

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Investment advice offered through Stratos Wealth Advisors, LLC, a registered investment advisor.  Stratos Wealth Advisors, LLC and Wozny Capital Advisors, LLC. are separate entities.

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