Risk is hard to see and quantify for most people. It is abstract; it is not perceived in the same concrete manner as investment returns. A performance report shows you a percentage return. You can see that return, understand it, and quantify it. It translates easily into dollars and cents, gains and losses. It is concrete. You know that “ABC” ETF returned 19% last year. But what was the risk?
Risk seems more abstract: it could have gone down, or it could have gone up less. But there is a way to measure risk. If you are like most people, when you read the words standard deviation, your eyes gloss over, you think of that high school math class you hated, and you move on, leaving it for someone else to worry about. Standard deviation is a measure of risk and I’m going to break it down into a clear, simple understanding of it so that you can visualize and quantify it just like a percent return from your performance report.
How To Measure Investment Risk
If you follow the S&P500 index, you might see that your 10-year average annual total return was 13.76%* at the time of me writing this (February 9, 2021). Ok, simple enough. But what was the risk you were taking? The 10-year standard deviation for the S&P500 is around 13.55%. What does that mean? You will understand it in about a minute.
All that means is that there is a 68% that your 10-year annualized return could’ve been between 0.21% and 27.31%. So, you were risking a 68% chance of having that range of returns for an actual return of 13.76%.
Furthermore, there is a 95% chance that the return would’ve been between -13.34% and 40.86%. That is the risk you were taking.
You can calculate this by utilizing the rule that states: 68% of the returns are within 1 standard deviation of the mean. 95% are within 2 standard deviation of the mean. And 99.7% of the returns are within 3 standard deviation of the mean.
That’s a huge variance in returns and characterizes the risk being taken. It helps to compare it to a safer investment, like the Bloomberg Barclays U.S. Aggregate Bond Index (the Agg). The 10-year annual total return for the Agg is 3.86%**. The 10-year standard deviation is 2.93%.
Therefore, there’s a 68% chance that the Agg’s 10-year return would be between 0.93% and 6.79%. And there’s a 95% chance it would be between -2.00% and 9.72%.
Standard deviation is a measure of investment risk, i.e. the probability or uncertainty of losses rather than expected profit from an investment. It also can be affected by market risk, which is the risk of losses due to overall market performance. We manage these risks through diversification of investments1. This is just one reason why risk management is important. But that’s not the only risk in a risk management plan.
Financial Planning Risks
Again, this is where risks can become more abstract. Risks are not only tied to investment performance. There are additional, external risks that should be addressed with robust risk management. A risk management plan starts with risk identification. First, we identify the risks that are out there. Then, a risk assessment is undertaken whereby we prioritize the potential risks and threats. Then, we come up with solutions to them.
Designing a financial plan and risk management can be compared to driving a car. We know you need to get from Point A to Point B. And we know we have a solid car. So, let’s make sure we are driving the speed limit and not taking on any undue risk that might derail you getting from Point A to Point B. We don’t want you to get in a car crash or pulled over for speeding. At the same time, there are factors we can’t control like the other drivers out there, maybe a deer jumps into the road, or maybe there’s a traffic jam. We can’t control those. So, instead, let’s have a contingency plan for those factors we can’t control in case we do encounter them.
Let’s make sure your seatbelts are buckled, your tires are filled with air, and that your airbags work. If it’s a long road trip, let’s make sure you have some snacks and water so you don’t have to stop every so often and in case there is a long traffic jam. We approach financial planning, retirement planning, and risk management in much the same way. We want to plan for the what-ifs and to have contingency plans.
Long Term Care Risk
What are some of these external risks? Some of the most common external risks we see are long term care costs. You might have built up a very impressive investment account over the years, but it could be drained very quickly if you had a long-term care need. An estimated average for an assisted living facility is around $60k per year. So, obviously we want to protect these assets so you can live off them or pass them to your loved ones. One way to manage that is through insurance.
Life And Disability Insurance
Another risk we commonly address is the risk of a bread winner in the family either dying or becoming disabled. If this happened, the family would no longer have that breadwinner’s income. So, to manage that risk, many times we transfer the risk to an insurance company through a life or disability insurance policy. These are obvious reasons why risk management is important. It is about looking for potential risks and threats to your plan. It is about protecting your lifestyle and your assets.
By default, we provide stress tests on your entire financial plan that show how your plan would fare if the following risks played out:
- If equity markets crash by __x___%
- If tax expenses are higher by __x__%
- If inflation will be higher by __x___%
- If social security will be reduced by __x__%
- If you (and your spouse) live longer by __x__years
Lastly, an example of an internal risk that you can control is the risk that you spend too much and don’t have enough coming in. This is where the 4% rule of thumb comes into play, which we’ve referred to here in this post.
To learn more check out what we offer for risk management. Also find out which investment type typically carries the least risk.
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1 Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved.
* https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overview
** https://performance.morningstar.com/Performance/index-c/performance-return.action?t=XIUSA000MC