When you think about risk, do you immediately think of the probability that some unfavorable outcome will occur? Most of us do. However, risk is defined as the chance/probability that the result will differ from the expectations. So, inherently, risk can be positive or negative. Sounds counterintuitive, right? I believe the best way to understand this concept is to look at it mathematically and graphically.
Risk as Standard Deviation
You’ve probably seen risk defined as ‘beta’ or standard deviation or any other slew of metrics, but in today’s discussion, we’ll focus on standard deviation. If you want a refresher on other risk metrics at a high level, read this previously posted article I wrote, Investing Metrics, Key Risk Metrics (whitakerwealth.com).
Standard deviation, taking us all back to our grade school days, measures the volatility or dispersion from the mean. Simply put, standard deviation measures the probability that a result/outcome will land within n-standard deviations of the mean. In this example, the mean is the expected outcome or expected return for the investment/security.
Let’s take a look at this in graphically
Source: scribbr.com
‘M’ here is the mean, and the dispersion from the mean is shown as standard deviations. The standard deviation values are important. Imagine that you have an investment that your purchase price was $50/share and this purchase price (hypothetically, of course) was the same as the mean over the specified timeframe.
This means that:
Your investment should have a return 68% (1 SD) of the time between $40-60
Your investment should have a return 95% (2 SD) of the time between $30-70
Your investment should have a return 99% (3 SD) of the time between $20-80
Or rephrased:
Your investment should have a return >$60 or <$40, 32% (1-0.68) of the time
Your investment should have a return >$70 or <$30, 5% (1-0.95) of the time
Your investment should have a return >$80 or <$20, 1% (1-0.99) of the time
So, the question remains: Is this risky calculation/measurement actually risky? Standard deviation measures the probability of upside and downside risk, but when I think of risk, I only consider the loss possibility.
Great, so let’s revisit with only the downside risk.
Downside Risk
Only looking at downside risk:
Your investment could have a return 34% (1 SD) of the time between $40-50
Your investment could have a return 2.5% (2 SD) of the time between $30-50
Your investment could have a return 0.5% (3 SD) of the time between $20-50
Or rephrased:
Your investment could have a return <$50, 34% of the time
Your investment could have a return <$30, 2.5% of the time
Your investment could have a return <$20, 0.5% of the time
Did you notice I changed should, to could? – This is called framing; we’ll discuss that in a future post!
Sortino Ratio
Well, that’s a bit easier to grasp and aligns with the way I see risk in the market. So, how can I understand the standard deviation of my portfolio and measure it against the market? There is a metric called the Sortino ratio. This ratio is a risk-adjusted return metric focused on downside deviation and risk. If you’re a risk-averse investor, consider discussing this ratio with your advisor. More importantly, make sure you discuss your risk tolerance, time horizon, and goals.
Our team of financial advisors at Whitaker-Myers Wealth Managers is well-versed in metrics and how to align your goals with results. Schedule time with our team to discuss and if you have any topics you’d like for me to address, please submit them here.
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