1. Standard Deviation & the Measurement of Risk
In statistics, standard deviation is used to measure the extent to which numbers are distributed around the average. For investors, it is the usual means by which they can measure the historical volatility of an individual share, fund, or portfolio, by measuring its distance from the average.
The illustration below shows a typical bell curve of the distribution of investment returns. The chart plots the number of occurrences of a monthly return. The average distribution is at the centre of the bell-curve. If the distribution is normal, one standard deviation added or subtracted from the average encompasses about 68% of the occurrences. Two standard deviations would account for 95%.
For example, if the average return for a portfolio is 13% and it’s standard deviation is 20%, we would expect returns to fall between -7% and +33%. A standard deviation of 10% would give expected returns in the range +3% to +23%. The wider the range of returns, the more risk there is in the investment. Clearly, although the deviation can be higher or lower than the average, it tends to be the downside deviation that causes the investor pain and which they need to be aware when selecting a portfolio to match their risk capacity.
2. Asset allocation and Portfolio Construction
Having established the factors of risk that can be combined to form a suitable portfolio – and a means for measuring its risk – we can now step through the process of building a portfolio. The example below is based on the shape of Swindells Financial Planning Ltd’s Portfolio 60 with 40% invested in fixed income.
The process of diversifying the portfolio to capture the five dimensions of risk identified by Fama & French generally has the effect of increasing expected return with no additional, or even reduced “cost” in terms of risk. The methodology could be used to construct any number of portfolios by combining different percentages of the available components.
3. The Efficient Frontier
Optimal or efficient portfolios are theoretical concepts and are achieved when a portfolio provides a maximum mathematical return for a given level of risk. In order to determine these efficient portfolios it is necessary to analyse every combination of assets and plot the expected risk-return outcome for each combination. The optimal or efficient portfolios are then defined as those which maximise the expected return for the desired level of risk.
Having established the expected outcomes for all the combinations of assets, a line can be drawn to join up each of the optimal portfolios at each risk level; this line is known as the Efficient Frontier. This is illustrated in the diagram below.
There are no portfolios with better theoretical risk-return profiles than those plotted on the Efficient Frontier.
It is clear that for any given value of standard deviation (risk), you would like to choose a portfolio that gives you the greatest possible rate of return; so you always want a portfolio that lies up along the efficient frontier, rather than lower down, in the shaded region. This is the first important property of the efficient frontier: it is where the best portfolios are.
Our objective therefore is to determine which portfolio will place you at your optimal point on the efficient frontier. That is, there is an acceptable balance between the amount of risk you incur for the level of your expected return, thus allowing you to maintain investment discipline.
4. Investment Discipline
The investor’s chief problem – and even his worst enemy – is likely to be himself.
Benjamin Graham “Security Analysis”, 1934
Investing is often likened to a ride on an emotional roller coaster. If you consider the typical behaviour of the vast majority of investors, you can understand why. When an upward trend – either for an individual stock or indeed the market as a whole – starts to emerge, the investor follows the trend but only buys in once he is convinced that it is for real. Unfortunately, this is usually at the point that all the gains have been had and the trend reverses. Thus, it can be seen how the emotions that drive investors are a powerful force that lead them to buy high and sell low.
The solution therefore is for the investor to select a portfolio that would allow him to remove his emotions from the investment equation. This can be achieved by the use of a portfolio of globally diversified index funds, tempered with a fixed income component to reduce volatility. This allows him to stay invested at a risk level with which he feels comfortable and which minimises his urge to move. In that sense, it could be said that the stock market is like a wild bull trying to buck investors off its back. The investor’s objective is to find the bull he can stick with and ride until the buzzer sounds. The buzzer in this analogy represents an investor’s need to withdraw his funds from the market at a time of his choosing.
5. Consistency Beats Volatility
For most investors, the emphasis placed on maintaining discipline by professional investment advisers is interpreted to mean: stay with the strategy even when times are bad. In fact, recent history shows it was exceptional investment returns, such as those experienced during the tech stock bubble of the 1990s, rather than adverse market conditions that proved the biggest challenge to staying with the programme.
It is often said that the two conflicting emotions that rule investors are fear and greed. But we must add to that the basic human instinct for “belonging” and “acceptance”. In other words, if your peer group appears to be making a fortune from the latest hot stocks, you not only feel that you are missing out (greed) but also that you are not one of the in-crowd (acceptance). The loss of “bragging rights” in the golf club bar has thus tempted many otherwise rational investors to abandon sensible, long-term diversified strategies in favour of short-term gratification which they later repent at leisure. Or perhaps not at leisure – as their retirement plans are postponed because their investments have failed to perform.
Any investors who find themselves challenged in this way should take comfort from the mathematics underpinning the concept that consistency beats volatility and that a globally diversified portfolio of “boring” index funds will beat the “exciting” hot stocks over the long-term.
Returns on a single premium of £100,000 invested at the beginning of a compounding period.
6. Rebalancing Portfolios
Rebalancing a portfolio is an important factor in achieving long-term returns. If you accept that your risk capacity should be matched with a suitable portfolio then rebalancing is the means by which you maintain a consistent risk exposure. For example, after a prolonged bull market the balance of equities and fixed income in your portfolio might have shifted from 60/40 to 70/30 – leaving you more exposed to the downside than you are prepared for.
Although rebalancing is a simple concept, realising its benefits is a challenge for many investors because it involves selling assets that have recently done well and buying assets that have recently done poorly in order to return to the original allocations. However, an understanding that, over the long-term, asset class performance tends to be mean revert (i.e. periods of above average performance are followed by periods of below average performance) rather than maintain upward or downward trends indefinitely, will help the investor overcome his reluctance to do what appears to be counter-intuitive – i.e. sell a successful investment rather than hold on to it.
Rebalancing has been proved to increase portfolio returns with no additional cost in terms of risk. However, it is not an entirely ‘free lunch’ as, in order to rebalance, some transactional fees and expenses may be incurred. The key, then, is to maintain discipline as to when and why the portfolio will be rebalanced. As a general rule, a portfolio is tested quarterly and rebalanced when necessary – usually on an annual basis to revert to its original allocation. In addition, your risk capacity should be measured annually or when a significant life event occurs: loss of job, marriage, divorce, birth of children or death, to determine whether any structural change in asset allocation is required.