One of the things we preach is that “you don’t need to know everything if you know the right things!” It is easy to get stuck in the weeds of investing if you get bogged down attempting to learn “everything” or, at least what the general consensus thinks is everything. Just knowing the important, “right things” can make all the difference between an angst filled investment experience and a stress free one.
Recently when we were discussing how to live the "good life," we answered a question and discussed one of the “right things,” standard deviation (Std Dev). Now don't roll your eyes!! So why do you really need to know what this is and its importance to you as an investor? Not wishing to spend even substantial minutes in explaining this statistical term, suffice it to say it is one of the important ways in which we measure risk in a portfolio (or volatility and/or fluctuations if you prefer).
The issue for investors is: just what is risk and when you are creating a portfolio or asking an advisor to create one, how can you communicate just how much risk you wish to assume? Most are familiar with the terms generally associated with risk. It might be that you request a “conservative” or “moderate” level of risk. Now please explain to me exactly what those terms mean with respect to the level of risk in your portfolio? My definition or understanding of those words, as they apply to a portfolio might be totally different than yours or vice versa. Thus, the reality is neither of us really understand just how much risk you are willing to take because for this, words are too imprecise!
Enter std dev. This gives us a measured number describing the level of risk/volatility/fluctuations that can be “expected” in any portfolio design. Thus, by use of this statistical tool we can eliminate misunderstandings about expectations and likely future disappointment in an investment portfolio’s performance.
As I write at the outset, it is not my intention to teach a course in statistics nor to get into the weeds when it isn’t necessary, so here’s the sum total and all you really need to understand as an investor: the higher the std dev number, the greater the expected volatility or fluctuations (risk of the portfolio).
Is it “guaranteed?” No, all it is, is the best that we can predict with the state of knowledge we have regarding the long term expected rates of return and the fluctuations that occur to them over time. The more data points we have the more accurate the prediction but there is no 100% certainty.
If we know what the long term “expected” return is (keep in mind expected is not a guarantee – two different animals), std dev tells us what the expected parameters of deviation, plus or minus from these returns we should expect. So, in the real world the way this works is: if we have, say an expected long term average rate of return of 10%, depending on the asset mix we use, the std dev could tell us by it’s number that we might expect the returns to fall in any measured time period between say +15% to -18% and any returns falling within these parameters would meet the expectations of the portfolio design if that std dev was acceptable to you.
The bottom line to you the investor is: you now know how much your portfolio could be expected to gain or lose in any measured period of time. Isn’t this better to know than a meaningless descriptive of the level of risk in your portfolio than: “aggressive,” “moderate” or “conservative?”Now you’re truly able to make an intelligent and informed decision regarding the level of risk you’re willing to assume!
So learn one of the right things and know or ask so you can know just what your portfolio's std dev number is! How do you find out? Ask me or your current advisor and if your current advisor can't tell you, then maybe you ought to be talking to me!
A final word: risk means that what you expect to happen just may not. It is the assumption of risk and the level of it for which you are seeking to be compensated as an investor. In other words, no matter how rosy a picture is being painted or assumed, you are being compensated for the risk of losing some or all of your money – as crypto currency investors have been recently finding out.