Balancing Risk and Reward in the Market
Many investors look at investing as a kind of horse race: To "win," the logic goes, you must beat the market.
While measuring performance against a market index such as the S&P 500 may be a simple way to gauge success, in the long run it may be harmful to your investing results. To understand why, let's look at the concept of risk-adjusted return.
Risk-adjusted return can be defined as the measure of how much risk an investor has taken on to achieve their earnings. Let's say two mutual funds post identical 10% returns. The less aggressive, less risky of these funds would be said to have the better risk-adjusted return.
Over time, the riskier investment is prone to greater fluctuation, including greater losses, than the more conservative one. And good investors seek to smooth out that fluctuation. Why? Because substantial losses can undermine the very goals behind our investing—such as a comfortable retirement.
Significant losses pose a particularly thorny problem for investors who are retired or nearing retirement, because they have little or no time to recover big losses.
To illustrate this point, let's look at a hypothetical investor named Ted. In 2007, Ted had $1 million in retirement savings. Ted abhorred the idea of possibly earning less than the market, so he invested all his money in the S&P 500 index of large-cap companies. Sure enough, his 5.5% return matched the market's return that year, earning him $55,000.
Then came 2008. Again, Ted was all in on the S&P 500. We all know what happened, of course: The market plunged 37%, reducing Ted's assets to $664,650.
Ted's loss would not be easily recovered. Because his capital base had shrunk so dramatically, he had lost considerable compounding power. Ted would have to earn more than 50% to recover his losses, a prospect that required multiple years of successful investing results. In the event Ted needed to draw income from his portfolio, he would be in even more serious straits.
All of this helps to explain why we at Acorn Wealth Advisors focus on risk-adjusted return rather than pure return. To do this, we carefully counterbalance stocks, bonds and other investments that have complementary risk and reward characteristics.
Our approach typically won't crush the market. But over the long term, limiting losses and earning good gains should help you achieve your goals. In addition, mitigating dramatic swings in your portfolio can do wonders for your peace of mind. Please contact us if you'd like to learn more about investing to achieve your unique goals.
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