Valley Wealth

The relationship between risk and return

Most people intuitively know that risk is inversely related to return. The higher the risk, the greater the potential for a higher return and the greater potential for loss. Investors expect to be rewarded with higher returns in exchange for accepting greater risk and accept lower returns in exchange for lower risk. A major goal of designing and managing an investment portfolio is to maximize total return while keeping overall risk to an acceptable level.

 

Measuring risk

Risk has traditionally been measured by volatility; an asset whose price varies dramatically is considered riskier than one that is more stable. However, some experts have begun to question whether a portfolio can be better optimized by focusing on downside risk, arguing that such an approach more closely matches the way investors tend to think.

Most investors are  not as concerned with how an investment's return deviates from its statistical mean--its ups and downs--but on how often its returns fall below a minimum acceptable return, how far below that figure they fall, and the potential worst-case scenario possible for that investment. Outlined in Managing Downside Risk in Financial Markets by Frank Sortino and Stephen Satchell of the Pension Research Institute, this approach attempts to combine portfolio theory with behavioral finance, hoping to more closely reflect the human decision-making process.

Valley Wealth, Inc. strongly believes that if we do a good job managing our clients’ emotions and behaviors, then their opportunity for a relatively high investment return is increased.  Many studies have shown that investors who have earned historically low returns have not done so because they picked poor investments.  Lackluster returns are most often caused by “buying high and selling low” and not what most would prefer in “buying low and selling high.”

When a portfolio experiences huge valuation swings, any rational human being will move away from logic and toward emotion.  How the investor acts on that emotion will be the key difference between future success or failure.  Valley Wealth, Inc. helps to keep their investors cool and calm by focusing on a very important variable:  correlation.

 

Correlation: selecting diverse asset classes to reduce risk

Combining different asset classes within a portfolio is called diversification. The goal of diversification is not simply to have many different investments, but to combine complementary investments so that the resulting portfolio will perform well during the investor's time horizon. To accomplish this, it helps to understand the concept of correlation.

Correlation measures the similarity of investments' price movements over time. When the prices of two different investments move identically, they are said to have a correlation of 1.0. When the prices move in exactly opposite directions, their correlation is -1.0. A correlation of 0 means that price movements are unrelated to each other, so that a price movement of one investment is not useful in predicting the price movement of the other.

A well-diversified portfolio consists of asset classes that are not closely correlated to each other. For instance, say a portfolio consists of stock asset classes that include stocks in U.S. companies in the Large Cap, Mid Cap, and Small Cap categories. This portfolio is not well diversified, because historically all classes of U.S. stocks have tended to be closely correlated. The addition of less correlated asset classes such as foreign investments, bonds, and real estate would add significantly to the diversification of this portfolio.

Average financial advisors might only use a few asset classes that are not strongly correlated to the bulk of your holdings.  But this is where Valley Wealth, Inc. stands apart from the rest.  We make concentrated efforts to not overweight your portfolio with assets that have historical returns that are highly correlated.  We go beyond the usual suspects of US stocks, foreign stocks, bonds, and real estate, and move into a territory many investors have never experienced.  Precious metals, commodities, natural resources, currency, and other “specialty” asset classes are all used as part of our proprietary Stock LimitTM Portfolios. Click here to learn more about the Stock Limit ^TMPortfolios.

What was once considered the domain of the “big-time” investor has become accessible to a wider audience.  Because of our Modern Thinking, our clients have been able to experience consistency in their portfolios.  Our goal is to give them the same returns they had hoped for with a more traditional portfolio, but to keep them in positive territory more often, and away from the huge swings of the stock market.