Investment Risk and Return
An Overview

Balancing risk and return is a dilemma that every investor faces. But armed with the appropriate knowledge, quantitative tools and data, you can maximize your portfolio's return at the level of risk that is appropriate for you.

Each investor has to determine the level of investment risk that is appropriate for them in terms of risk tolerance, financial condition and life situation, with life situation largely determining financial needs. Obviously, a balance needs to be established between risk tolerance and the other factors. Unless you are very well off or have a darned good pension, you can't afford to keep all of your assets in CDs or a laddered portfolio of Treasury bonds, so you will have to accept a little more risk. Getting a feel for the risks you may be exposed to as an investor is the first step toward establishing the balance that is right for you.

Investment risk can be categorized as specific, which is diversifiable, and systematic, which cannot be diversified away and therefore must be factored into each investor's balance between risk and return. One of the primary objectives in assembling a portfolio is to eliminate your exposure to specific risk. How far you go with this depends on the universe of assets that you choose to work with. Here universe refers to the set of assets that you decide to limit yourself to, which can be as narrow as just domestic large-cap stocks and very high quality bonds or as broad as the total U.S. and international stock markets, the world bond market, emerging markets and world real estate. The broader your diversification, the more favorable your balance between risk and return.

Specific risk, also referred to as company-specific risk or nonsystematic risk, is the aggregate risk that is specific to each company, arising from such things as managerial expertise, R&D, patents, pending law suits, labor relations, supplier relations, customer relations, etc. Specific risk also includes micro economic factors specific to each industry that affect all firms in an industry, such as seasonal fluctuations in demand and the prices of input commodities. It has been shown empirically that these risks can be diversified away by holding a broadly diversified portfolio, usually referred to as the market portfolio, leaving investors exposed only to those risks that are inherent to the market as a whole, which, in the case where "the market" refers solely to U.S. common stocks, is only about ¼ the risk of individual stocks.

Systematic risk, a.k.a. market risk, consisting of macro economic factors such as inflation, war, fluctuating exchange rates, etc., cannot be diversified away and therefore is the residual risk that all investors are faced with and must be factored into their balance between risk and return. As noted above, the level of systematic risk is defined by one's universe. For example, if your universe is all publicly traded U.S. equities, you will be faced with systematic risk of about 17% as measured by the standard deviation of annual average returns from 1950 through 2006. By expanding your universe to include international equities, you can cut that risk by a much as one half, depending on your definition of international and which study you look at. Adding asset classes other than equities will reduce the risk further.

So the presumption is that in aggregate, investors are rational and that all rational investors will hold fully diversified portfolios, thus shedding all company-specific risk and thereby only being exposed to risk inherent in the market as a whole. The question you must answer is what you consider to be the market, i.e., your universe. The more expansive your universe, the more favorable your balance between risk and return.

By holding a Wilshire 5000 index fund, you will be, for all intents and purposes, totally diversified in domestic stocks. But what about bonds, real estate, precious metals and commodities? And what about international stock, bonds, real estate and commodities? And don't forget the emerging markets, as they're usually segregated from other international investments. If you want to be fully diversified, you need to be willing to accept the exposure to all of these asset classes. Although it may appear that you would be accepting more risk, the fact is that this exposure will actually reduce your total risk. In theory, you can minimize the level of non diversifiable risk in your portfolio by holding a market-capitalization-weighted portfolio of all the publicly traded assets available worldwide. The closer you get to total diversification, the lower the level of residual risk in your portfolio. Well-conceived diversification will change the relationship between risk and return in such a way that ratio of return to risk increases with diversification, i.e., more return per unit of risk.

Mutual funds, with the exception of concentrated funds, are broadly diversified within their respective universes, which should be defined in their prospectuses. But that only means that they've diversified away the specific risk within their universes. Consider sector funds. A sector fund should be broadly diversified within an industry, but because it is only invested in one industry, that portion of specific risk that is common to all firms in that industry will not have been diversified away. By the same token, a Wilshire 5000 index fund will only have diversified away 100% of the specific risk of the U.S. stock market but does nothing to address the diversifiable risk of other asset classes. Call it risk by exclusion, if you will.

Getting risk into perspective is difficult, but it's something you must do if you want to achieve the proper balance between risk and return. It's a simple and unavoidable fact that the value of your investments will fluctuate. Even the value of cash fluctuates, as its value is affected by inflation. So you need to assess your tolerance for risk in both the financial and psychological contexts. In other words, how much you can afford to lose or underperform your target return over a given period of time and how much you can stand to lose without the need for psychotherapy.

How much you can afford to lose is a decision you need to make with your financial planner, I can only give you guidance that will help you estimate the probable variance of the value of your portfolio. The following subsections should provide that guidance and serve to get risk in perspective for you so that you can find the balance between risk and return that's right for you.

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