Investors have many options to choose from when they are building their portfolios. In choosing their investments, investors must weigh the tradeoff between the returns that they seek and the amount of risk that they are willing to take to achieve those returns.
When analyzing an individual security or a portfolio of securities, the most commonly used financial measure of investment risk and consistency is standard deviation. A fund with a high standard deviation shows price volatility. A fund with a low standard deviation tends to be more predictable. To assess the volatility of an entire portfolio, you calculate its standard deviation based on three important factors: the standard deviation of each of the assets in the total portfolio, the respective weight of that individual asset in total portfolio, and the correlation between each pair of assets of the portfolio.
Consider two similar mutual funds: Fund A has a 10% average return and a 10% standard deviation, while Fund B also has an average return of 10% but a standard deviation of 15%. Given these similar options, a sensible investor would be expected to choose A because it offers the same return as B but with a more consistent return pattern.
To visualize the standard deviation for our Fund A, see the bell curve below:
Assuming a normal distribution of returns, about 68% of Fund A’s returns will fall within plus or minus one standard deviation of the average (10%). About 95% of its returns will fall within plus or minus two standard deviations. In theory, that means about 68% of the time our example mutual fund will have returns between 0% and 20%. At a 95% level of confidence, the range would be -10% to 30%. On top of that, we would expect over 99.9% of this fund’s returns to fall within plus or minus three standard deviations, which is between -20% and 40%.
When building a portfolio that will be distributed over the course of your retirement, it is important to know how volatile the returns will be so you can manage the overall portfolio risk level accordingly. On top of making sure that you are being properly compensated for the amount of risk, you also have to make sure that the underlying principal nest egg is protected from significant downside risk.
When you begin to take distributions from your retirement nest egg, the combination of their distribution rate and the overall portfolio standard deviation will dictate to a great extent how long your portfolio will last. For most retirees, their goal is to continue to grow their portfolios in retirement and maintain a certain lifestyle without ever having to worry about running out of money. The advisors at Baird Retirement Management can show you exactly how this is done, and what it takes to have a successful retirement.JG2021-1026