In order to manage risk you first must be able to measure it. The more likely an investment is to go up and down in value over the short term, the more volatile it is. When you hear about an investment risk level, it is usually referring to volatility.
More volatile investments, such as stocks, may show losses some years but have historically earned higher returns over time. More stable investments, such as CDs, rarely loss money in a given time period, but earn less over the long term.
Standard deviation is used more than any other measure to describe the risk of a security or a portfolio of securities. Standard deviation provides a precise measure of the amount of variation in any group of numbers that make up an average. Standard deviation is the statistical measure that represents total risk and is the most stable of the volatility indices. This measurement of risk (volatility) describes how much fluctuation you can expect your portfolio to have. The higher the standard deviation, the higher the volatility around the average rate of return.
If the average rate of return or mean and the standard deviation of an investment are known, you can obtain some useful information by simple arithmetic. By putting one, two or three standard deviations above and below the mean you can estimate the ranges that would be expected to include about 68%, 95% and 99.7% outcomes.
Waverley Research's portfolio has a mean of 13.22% and a standard deviation of 12.11. The charts below will compare the volatility of Waverley Research to the Dow Jones Industrial Average (DJIA) from 2005 through 2012. These charts can assist you in determining if the Waverley Research approach is appropriate considering your tolerance for risk, time horizon and investment goals.
|Waverley Research||-1.11% to 25.33%||-11.00% to 37.44%||-23.11 % to 49.55%|
|DJIA||-5.80% to 25.48%||-21.44% to 41.12%||-37.08% to 56.76%|
Standard deviation does have a drawback, it is not intuitive. A standard deviation of 8 is obviously higher than one of 6, but an investor contemplating a purchase does not have a reference point. Because standard deviation is not a relative measure, it may not make much sense unless you compare a portfolio's standard deviation to a benchmark. Waverley Research used the DJIA as its benchmark
To measure risk many investors turn to beta, a measure of the volatility, or systematic risk, of a portfolio. While standard deviation determines the volatility of a portfolio according to the disparity of its returns over a time period, the beta coefficient determines the volatility, or risk, of a portfolio in comparison to that of its index or benchmark. Essentially, beta is a comparison between the movements of an individual stock or portfolio of stocks and the movement of the market, index or benchmark as a whole.
The market has a beta of 1.0, and a portfolio is ranked according to how much it deviates from the market. A stock that swings more than the market over time has a beta greater than 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. A beta of 2 suggests that the portfolio will fluctuate twice as much as the market while a beta of 0.5 that the portfolio will move one-half as much as the market. Since inception the beta for the Waverley Selections is .39.
Conventional wisdom believes that investors seeking greater investment returns need to take on more risk by establishing a high beta portfolio. However, a growing body of evidence suggests a low beta portfolio performs just as well and, over some time periods, much better than a portfolio of high-risk portfolios and does so without exposing investors to as many of the wild highs and lows that have made investing so stressful.
For those sane enough to invest for the purpose of building wealth Waverley Research advises it customer to invest in safe, low volatility stocks with strong dividends. This is the approach of Waverley Research. This strategy may not be flashy, but it has worked much better lately and involved far less risk.
Finally, to be a successful investor and to effectively manage risk a sound exit strategy must be established should the market drop rapidly as it did in 2008. To avoid losing too much money to a stock market correction a stop loss order helps you manage risk. Simply put, a stop loss order is an order that you place at the same time you enter a position and specifies that your investment be sold when a certain price level is reached. When the specified stop price is reached the stop order is triggered automatically, a market order is created and the stock is sold. The goal is to keep your possible losses from any one trade to a predetermined and acceptable amount.
Our recommendation is to not allow any one investment approach to be capable of damaging a portfolio more than 1% in a worst case scenario. Since we advised that no individual investment approach exceed 5% of a portfolio a stop loss of 20% would satisfy this requirement.