Risk or Return…or Both?

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Imagine for a moment you were presented with the opportunity to swim across the Hudson River in a contest for $1M.  The unique aspect of this content is that as long as you crossed the river from New York to New Jersey in under 20 minutes, you would be given $1M.  You didn’t have to be first — you just had to beat 20 minutes.

What would you do?  Would you jump in the water and swim as hard as you could for 20 minutes and pray that you made it in under 20 minutes?  Or would you determine the best area of the river to make the journey, put on a life vest and swim hard enough so that you could sustain your endurance yet cross in under 20 minutes?

If you’re a rational person, you likely picked the latter.  With your goal in mind, you would cross the river with a plan for managing the unexpected.  If that’s your perspective for crossing a river in a mythical contest, why is that perspective often lost in the real world of investing?

Money can breed emotions that often aren’t rational.  Which is why working with a professional that you know and trust and who may be more objective may be suitable for some investors.

I always say to my clients that it’s very easy to put together a portfolio of investments.  The difficult part of an advisor’s job is putting together a portfolio that has a strong probability of meeting a client’s objectives.

Step one is determining the return that a client needs in order to hit his or her goal.  The next critical step is determining the appropriate level of risk that may be taken in order to reach that goal.  In portfolio construction, both go hand in hand.

Future return may be estimated by looking at a portfolio’s historical returns — ideally, during similar times in the economy such as during a past recession.  Past performance is not a definitive indicator of future performance, but may help you gain clarity on how an investment may perform.

Risk in my book is the chance that your portfolio won’t provide the performance, or return, that you need in order to hit your goal.  This a Modern Portfolio Theory point of view.  As a result, leveraging factors such as a client’s personal tolerance for risk, the portfolio’s standard deviation (which is a tool for measuring volatility), R-squared, beta and alpha may help determine the chance that a portfolio may or may not hit a return goal.

A common misconception is that in order to produce higher returns, you have to take on higher levels of risk in your portfolio.  But if you know for a fact that you’ll receive higher returns, the implication is that the investment is not necessarily riskier given the certainty of making high returns.  Unfortunately, there’s no guaranteeing returns.  There is more guarantee, however, in managing against not landing in the ballpark of the return that you need.

By doing the latter, you may put yourself in a better position to cross the river instead of being hit by an unexpected wave and petering out midway through your journey.