How Risk Can Hurt You

Last week’s column on investors’ apparent indifference to risk got at least a few readers wondering why risk really should matter, or to be more specific, why we should be risk-averse if risk and higher returns tend to be correlated in the long run. One obvious answer is that if you have $1 million in the market today, it’s comforting to know that there isn’t a good chance that you’ll have $500,000 in the market tomorrow. It’s hard to plan a financial future if there’s no stability to your returns.

The more important reason is that wild swings in your rate of return make your cumulative return smaller than it would have been if your rate of return stayed steady. Here’s how it works (forgive me if this is obvious):

Take two portfolios of stocks, each with an initial value of $100,000, which average a 20 percent return over the course of three years. (I know, 20 percent is painfully low by today’s standards, but let’s just go with it.) The first portfolio is considerably riskier, which is to say it is made of up of stocks with much higher volatility. It jumps 50 percent the first year, drops 20 percent the second year, and rises another 30 percent the third year, for a mean annual return of 20 percent. At the end of the three years, this portfolio is worth $156,000 ($150,000 after the first year, $120,000 after the second, and $156,000 after the third).

The other portfolio is made of stocks with much lower volatility. It rises 24 percent in the first year, 17 percent in the second, and 19 percent in the third, again for a mean annual return of 20 percent. But this portfolio is worth $172,645 at the end of three years.

It probably seems–actually, it probably is–harder to pick stocks that will rise 20 percent with low volatility than stocks that will rise 20 percent with high volatility. But if you’re going to try to pick stocks, that’s exactly what you need to do to maximize your returns. Risk’s potential costs are not imaginary or psychological. They’re economic.