The Theory of Relativity
I would be lying if I said I understood and could explain Einstein’s Theory of Relativity. His theory actually comprises two theories, Special Relativity and General Relativity. Of course, everyone knows the famous formula E=mc2. I do know that it paved the way for enormous advances in physics and astronomy after his development of the theories in the early 1900’s. Besides that, I would be hard pressed to provide much more detail.
For an entertaining take using some of Einstein’s ideas, I would highly recommend my son’s favorite movie, Interstellar. A Nobel Laureate in Physics consulted on the film. I raise the idea of relativity to explore the relationship between risk and return.
Thomas Sowell, Professor of Economics at Stanford University, tells a joke about an economist walking down the street who encounters an acquaintance. The acquaintance asks the economist, “How’s your wife?”. The economist replies, “Compared to what?”.
The punchline drives home the importance of the relation of one thing to another. Too often, investors are laser focused on the performance of a stock, a mutual fund, or exchange traded fund, while ignoring the risk of a specific investment. There is a simple reason the boiler plate language: “Past performance is no guarantee of future results” is plastered on almost all financial filings, advertisements, and investment research. It is true.
There are several ways to measure risk in a portfolio. CERTIFIED FINANCIAL PLANNER™ practitioners and Chartered Financial Analysts are required to learn and apply financial formulas that calculate risk in a particular investment or portfolio. The most commonly used formulas are the Treynor Measure, Sharpe Ratio, and Jensen Measure. They each result in a single value by the combination of risk and return, although using different methods.
For example, the Treynor Measure looks like this:
Treynor Measure= PR-RFR
Where: PR=portfolio risk, RFR=risk free rate, and β=beta
The other measures are slightly different, and all can be used to measure overall portfolio risk.
It is important to note the distinction between systematic and unsystematic risk. The financial crisis of 2008 was a systematic risk. No amount of diversification would have helped. Unsystematic risk is specific to an industry or an individual stock. This risk can be mitigated by diversifying into other industries or non-correlated stocks.
So how does knowing there is a way to calculate portfolio risk help the average investor? Probably not so much. The bigger concern for most investors should be their appetite for risk. What do we mean by “appetite”? Often referred to as an investor’s risk profile, it includes goals, experience, time horizon, and investor behavior.
Goals, obviously, refer to the purpose of the investment. This include retirement savings, building wealth, education, vacation homes, or generating income. Goal setting is the cornerstone to financial planning.
An investor’s experience level is the foundational piece to understanding the types of investment vehicles that may be appropriate. A covered call options strategy is probably not something an advisor should suggest for a new investor with limited investment experience.
The time horizon for one’s investment savings are critical to gauge the amount of market exposure is deemed reasonable. If funds are needed in a year’s time, it is not appropriate to have any market exposure. The risk of loss due to market volatility is too great.
Investor behavior is how an investor reacts to market gyrations or volatility. An investor that sells into a capitulating market will often suffer losses they are unable to recover from. This is the key component of a risk profile to understand. Every advisor in the world has had clients who cannot stomach the turmoil of a market crash. A clear awareness of how an investor reacts in these situations is critical to designing a portfolio that minimizes the risk.
If the volatility of the market keeps you up at night, you may not be suited to investing in the market. This is unfortunate as the market can be a key factor in wealth building. A mantra I often repeat is “it’s not about timing the market, it’s about time in the market”. Set it and forget is also a good adage as long as re-balancing occurs on a regular basis. A professional advisor can help design an appropriate plan with a full understanding of an investor’s risk profile.
To learn how an independent, fee only advisor and a CERTIFIED FINANCIAL PLANNER™ professional can help you, please contact me. Feel free to share with others and make suggestions for future articles: firstname.lastname@example.org