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Understanding Common Risk Management Terms

Thinking through portfolio risk can be a challenging task without the right tools or an understanding of risk management concepts. Investors can lose sleep worrying if the markets are going to crash, leaving the equity portion of their portfolio exposed. Some people obsess about timing the market and keeping their portfolio in cash, only to end up missing out on market returns. Familiarizing yourself with the most common risk management terms and building a framework to comprehend the risk to your portfolio can give you peace of mind with regard to your financial plan.

Standard Deviation

This is one of the most common and often misunderstood measures of risk in financial markets. The calculation can be complex, but it can be distilled down to the degree to which a set of numbers varies around the mean, or average. A low standard deviation indicates that values have historically tended to be closer to the mean than another stock with a higher standard deviation.

Is a high standard deviation good or bad? The answer to this depends on your goals and appetite for risk. Standard deviation is synonymous with volatility in terms of risk management. The financial media will use the word volatility more often when the markets are trending down. It is important to remember that higher volatility simply means higher deviations from the average. An investment can be just as volatile if it moves suddenly up as opposed to a comparable downside move. We believe that waiting out periods of market volatility and staying invested for the long term in a diversified portfolio can be an accretive strategy.

The chart below shows the return of a bond index (orange, lower volatility), a global equity index (blue, higher volatility), and a diversified mutual fund that holds 60% equity and 40% bonds (purple) during the last 15 years1.

We believe that having a balance between fixed income, cash, equities, and other assets can help to smooth out returns over time by lowering volatility. Diversification may not help you to earn the highest returns possible, but we are of the opinion that it may help prevent you from making an emotional mistake and pulling out of the market.

Maximum/Potential Drawdown

This measures the maximum recorded loss from the high point of an investment to the low point. It is typically associated with a specific date in time, but could happen again at any moment in the future. It can be used to demonstrate the worst-case scenario for a single position, and can be broadly applied in stress testing how an entire portfolio would perform during turbulent times.

Drawdowns can be best illustrated by looking at some common U.S. equity names and their percentages off of record-high prices over time. Some of these stocks endured major drawdowns during recessions (shown by the grey bars below), but you probably could not point to why certain drawdowns happened in other periods, e.g., Netflix in 2011–2012. The drawdowns for an index like the S&P 500 tend to happen during distinct events in the economy because the company-specific risk is significantly lower. Investing in an array of equity holdings instead of concentrated bets on a few positions can diminish the effect of this risk.

Opportunity Cost

Opportunity cost can be thought of as the gap between maximizing potential return versus the return of your current plan. It is impossible to predict what the future will bring for the equity markets, so we cannot quantify future opportunity cost. However, we can use history as a barometer to see what opportunity cost has been.

The chart below is an example of $10,000 invested in a money market fund (purple) and a global equity index (orange) over the past 10 years. Holding cash can give you the flexibility to make large purchases or use it for living expenses, but there is always an opportunity cost to holding too much. At CPWM, we work with clients to optimize their asset allocation and find out the prudent range of cash and fixed income to hold over the long term. The remainder of your portfolio holdings can be used for growth, to minimize the opportunity cost. There will always be some opportunity cost to a financial plan, but we seek to allocate your assets in a manner that will allow you to participate in growth while protecting your spending needs.

Risk of Not Meeting Goals

We find most times, concerns about risk can be resolved by having a person who can answer your question: “Am I going to be okay?” At Columbia Pacific Wealth Management, we try to take the noise out of the financial markets and focus on this main question. By defining your spending needs, we can focus on building your financial plan around them. We then use robust financial planning software to find a range of possible outcomes that will seek to meet your spending needs.

Whether it is retiring early, starting a business, or leaving a certain amount of inheritance for your children, we want the focus to be on your lifetime plan. We will seek to manage risks by investing based on your personal goals, objectives, and constraints. If you have any questions about risk management, give us a call.

1. Graphs and charts are included for informational purposes only. No graph, chart, or formula can, in and of itself, be used to determine which securities to buy or sell or when to buy or sell securities.

Important Disclosure Information:

Different types of investments involve varying degrees of risk, including the risk of loss of your entire investment. Past performance is not indicative of future results. CPWM and its employees can give no assurance that the performance of any specific investment recommendation or investment strategy discussed herein, whether directly or indirectly, will be profitable, or that it will be equal to any historical performance level discussed herein. The discussion or information contained herein is not intended to be, and should not be deemed as, personalized investment advice. The recommendations made may not be suitable for your specific individual situation and we encourage you to discuss with your financial professional before undertaking any investment strategy or recommendation contained herein. The discussions contained in this blog is current only as of the date hereof and may change due to a number of factors, including varying market conditions.

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