Subscribe to Email Updates

  • Blog
  • Understanding Risk and Setting Realistic Expectations

Understanding Risk and Setting Realistic Expectations

Until the recent global equity sell-off, stocks had been on an upward trajectory for some time, with the S&P 500 Index—a broad measure of U.S. stocks—delivering six straight years of gains. An investor who’d bought shares in an S&P 500 Index fund at the last market bottom, on March 9, 2009 would have seen that investment triple in value before the latest downturn. At the same time, volatility, which measures the magnitude of swings in stock prices, had fallen to below normal levels for an extended period,[1] making it easier for investors to become complacent about the risks inherent in owning shares of publicly traded companies.

As volatility jumps and the current bull market endures its first correction in more than three years, now is a good time to learn more about the stocks you own and how to gauge the level of risk in your portfolio. Gaining a better understanding of the dynamic relationship between risk and return can help you set reasonable expectations about future performance and acquire the discipline to stick with a portfolio composition appropriate to your risk tolerance.

Volatility as a Guide

One of the most common ways to measure risk is standard deviation. This statistic measures the range of returns for different investments around their long-term average.[2] Comparing the standard deviations of different asset classes shows that stocks expose investors to a greater range of possible outcomes than bonds or cash. Over the last 10 years, stocks in the large cap S&P 500 Index had an annual standard deviation of 14.72% while bonds in the Barclays US Aggregate Index had a standard deviation of 3.27%.[3]

You can also use standard deviation as a starting point to compare the risks of different types of stocks. The Russell 2000 Index of small cap stocks, for instance, has had a standard deviation of 19.68%, meaning that small caps have been about a third more volatile than large caps over the last decade.[4]  Standard deviations for baskets of investments like mutual funds and ETFs are publicly available on websites like Morningstar.com and can provide additional risk assessments for different types of stocks.

Historical asset class returns (1926-2015)

Small Cap Stocks 12.10%
Large Cap Stocks 10.09%
Treasury Bonds 5.61%
Cash 3.43%

 

Compound average annual returns with dividends reinvested as of 7/31/15. Source: Morningstar.

Looking at the long-term historical returns of different investments, it’s not surprising that stocks that carry more risk, like small caps, have tended to deliver higher returns. What standard deviation illustrates is that those long-term average returns do not create a straight line upward. Investors must be willing to endure negative periods of volatility—like this month’s market sell-off—to benefit from the positive upswings that compound over time into higher account values. Knowing how much volatility you can endure without giving into the temptation to sell can help you maintain the discipline needed to be a successful investor.

[1] Jackson Wealth Management, “Current Market Trends” July 28, 2015 http://www.jacksonwm.com/#!Current-Market-Trends/c21xo/55b774430cf25b22c46fdf77

[2] http://www.investopedia.com/terms/s/standarddeviation.asp

[3] Morningstar

[4] SMALL CAP PERSPECTIVES RUSSELL 2000® INDEX QUARTERLY ANALYSIS

 

Volatility Bonds Diversification Economy Personalization Risk

Investing that works better for you.

No fads. No stock-picking. A smarter way.

Open an account