deviation by calculating a weighted average of the standard deviations for all of
the separate investments.
For example, take a portfolio that
tively. As an aside, note how the addition
of the conservative investment affects
the variability. A portfolio consisting of
100 percent of A would have a 95 percent
probability of returns ranging from – 30
SEPTEMBER’S VOLATILITY IS A HEALTHY
REMINDER THAT INVESTING IN STOCKS
INVOLVES TAKING RISK THAT SHOULD NOT BE
REGARDED LIGHTLY.
holds 40 percent of asset A and 60 percent
of asset B. The mean return and standard
deviation are 10 percent and 20 percent
for A, and 5 percent and 4 percent for B,
respectively. The mean and approximate
standard deviation would be 7 percent
( 40 percent x 10 percent + 60 percent x 5
percent) and 10. 4 percent ( 40 percent x 20
percent + 60 percent x 4 percent), respec-
to 50 percent—a very wild ride. But with
a 40/60 allocation of A and B, returns are
projected to be between – 13. 8 and 27. 8
percent.
Most investors generally are more
risk averse than they say they are. In
fact, most of them will cling to the positive returns at first. It is important that
you help them appreciate the poten-
tial downside risks involved. You need
to ask them questions such as: “How
would you feel about a 20 percent loss
in any one year? How comfortable are
you with a 20 percent chance of a negative return in any given year?” Otherwise, when the market has a month like
September, you will likely have a very
concerned and even angry client on
your hands.
Standard deviation is one tool you can
use to have this conversation. However,
like expected returns and annualized rate
of returns, standard deviation is an estimation that is imperfect and inexact, and
should not be relied upon to make guarantees and produce exact figures. Use it
ethically and prudently.
Kirk Okumura is an LUTC author and editor at The American College. Contact him at
Kirk.Okumura@TheAmericanCollege.edu.
