With the market levels where they are, there may not be a better time to discuss the difference between risk and return management.
When analyzing the success or failure of the management of investment portfolios, people usually look to total return and stack rank those returns against other managers or against an index. This does provide uniformity but may provide a distorted picture. How a manager derived their return is far more important than the return itself.
Risk and return are related. Aesop's tortoise and the hare fable applies to investing.
People often ask me whether it is a good time or bad time to put more money in the market? I get this question a thousand times a month and it is usually coming from two distinct directions. The first, the markets are racing is it a good time to get in? The other, the markets are too high is it really the right time to get in? Regardless of answer, this is an example of market timing. One thing to remember about market timing is that it is not a science, it is guesswork. This is mainly due to the fact that markets over the short term are irrational and driven by human emotion, not charts, graphs and other numerically tangible methods. Not saying this is wrongjust saying it is an example of return management. Other popular return management tactics involve day trading, picking only the highest performing funds, benchmarking and high water comparisons.
Return management is the hare. It is the gamble. It has more risk which is how it is able to potentially give more return.
On the other hand, you have risk management. Risk management is the tortoise. Methodical, unexciting, even tempered, not flashy.
By definition, a well-diversified portfolio should underperform during up markets and outperform down markets. Why? Because 100% of your account is in neither the best performing nor worst performing investments. You have a little in each. You take advantage of some of the gains while not realizing the full impact of the losses. You are taking less risk so you get less reward.
Here is a head scratching riddle for you. How can a portfolio with a lower annualized return than another actually give you more money in your account? It is actually possible for a portfolio to have a higher average return and leave you with less money at the end of the period. In the event of a negative return, you must use a geometric and not an arithmetic mean to calculate returns. In other words, if the events are linked and one is negative, you cannot take a simple average and apply it to your balance. Risk and volatility matter.
Investments can have higher annualized returns but if their intra period volatility was dramatically higher, then the amount of money you have at the end of the period could be lower. If you had $100 and lost 50% in a given year, you would need a 100% gain the next year in order to get back to $100. In this situation, you would have averaged 25% over the two years (-50 + 100)/2 = 25%. Your return is 25%/year yet you still have the same $100 you started with due to the massive volatility. If you limited the down and the upside in both years, you could end up with more money and less of an annualized return. For example, if you lose 30% in year one and had a 50% return in year two you would average 10% over the two years (-30 + 50)/2 = 10% but would have $105 at the end of year two. Losses hurt more than gains help. Don't think this scenario can happen? Just look back at 2008-2011.
This is why looking strictly at performance is never a good idea. HOW they get the return is far more important than the return itself. Managing volatility will get you to your goals in far better shape and without the roller coaster of emotion that comes with a moody market. Removing peaks and valleys gets you to the finish line in better shape. The tortoise will beat the hare. Do yourself a favor and throw away your benchmarks and ask your manager how they are doing what they do and what buffers do they have in place to manage volatility.
Joseph Colosimo is Divisional Senior Vice President and Regional Manager of Financial Services at Northwest Investment and Trust Services.