By John Spoto
While there are various types of investment risk, the proxy most often used by investment professionals is a statistical measure known as standard deviation.
In basic terms, standard deviation indicates how volatile and unreliable the returns of an investment can be. The more volatile the expected returns, the higher the standard deviation (and risk) because the chance of experiencing a large loss on the investment is greater.
For these reasons, bank savings accounts, high-quality bonds and stocks have low, moderate and high standard deviations, respectively. Because risk and return are correlated, we can expect (but are not assured of) higher returns from stocks than bonds and higher returns from bonds than savings accounts.
In 1952 Harry Markowitz, a Nobel laureate in economics and a pioneer in the area of finance known as modern portfolio theory, proposed that both math and common sense suggest that investors should consider both risk and return when making investment decisions. Furthermore, because investors are risk-averse, they should demand suitable compensation for taking on risk.
A rational person, therefore, will only invest in riskier securities if he believes the expected returns on those securities will be high enough to warrant taking on the risk. Otherwise, a prudent investor would choose less risky but equally profitable alternatives.
There are two central and related tenets of modern portfolio theory that have important implications for the everyday investor:
* First, by mixing different types of stocks that move up and down independently of each other, investors can reduce the volatility of their overall portfolio. This is known as diversification.
Markowitz further demonstrated that while diversification reduces portfolio risk, it does so while maintaining and potentially enhancing returns. This is why diversification is considered the one "free lunch" in finance.
* Second, because risk reduction through diversification can be easily achieved, the financial markets do not reward investors who fail to diversify their holdings. The result is what many investment theorists refer to as uncompensated risk.
Risk and return go hand in hand. However, for stock investments this relationship only holds true once they have been effectively diversified. Empirical research has shown that as investors move across the spectrum from broadly-diversified portfolios to those consisting of concentrated positions they become increasingly exposed to uncompensated risk.
In other words, there is additional risk for which they do not receive a commensurate return. At the extreme, some investors may hold a highly concentrated position of a single company stock, but more typical are those whose financial assets are skewed toward a small group of sector funds.
Sector funds are those that invest in a narrow slice of the market such as an industry like biotech or banking or a specific region of the world such as China or Brazil. They are diversified within an industry or geographic region but still expose the investor to unnecessary concentration and uncompensated risk. The explosion in niche exchange traded funds has attracted legions of investors who believe they possess superior insight into certain sectors.
There is no such thing as risk-free returns when it comes to investing. Those seeking to avoid risk will also avoid potential returns.
Markowitz taught us that smart stock-market investors focus on controlling risk, not avoiding it. The most effective way to accomplish this is by building a broadly-diversified portfolio rather than placing a big bet on a particular stock, industry or country.
Once the unnecessary risk has been wrung from the stock portfolio, the only one that remains is the risk inherent in investing in the market itself.
This risk is unavoidable, and for most investors will be challenging enough to handle.
John Spoto is founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com.