Sensible Perspectives

Navigating the Risk Return Maze

Posted by on August 25, 2015

Navigating the Risk-Return Maze

Sensible Financial begins by assessing the expected risk and return of your current investments, classifying each stock, bond and mutual fund into one or more of fourteen asset classes (six bond or fixed income classes, six equity or stock classes, commodities, and US real estate.)

We assign expected risk and return to each asset class based on historical data and current market conditions. We also assign correlations between all the pairs of asset classes (correlation is the tendency of a pair of asset classes to have the same pattern of returns).

Sensible Financial selects asset classes that tend to perform differently from each other over time. When one is down, another tends to be up. This relatively independent performance is the basis of diversification – reducing risk by spreading investment – the proverbial “not putting all your eggs in one basket.” Of course, there will be times when all are down, or all are up. On average, however, the diversified portfolio should be less volatile than the concentrated one.

We calculate the expected risk and return of your portfolio by assigning the appropriate asset class risks and returns to each of your investment securities, and adding up all of the returns and risks. Then we show you what might happen to your portfolio over time, and what might happen if you selected each of several alternative portfolios. You may find that you would prefer one of our alternative portfolios to your current one – you may be surprised by how much risk you are taking with your current portfolio, or by how little return you are targeting.

Finally, we ask you to choose the alternative you prefer. Only you can judge which portfolio you are most likely to be comfortable with. It’s important to be confident that you’ll be able to maintain your commitment to your investment plan even in the face of the inevitable declines that will occur. Changing your allocation in response to market busts and booms exposes you to the risk of selling low and buying high, with the associated damage to your returns.

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