Sep 13 Investments - The Risk Spectrum

In this video (the first in a series) we introduce the concepts of the Risk Spectrum, Risk Factors and what we call the Return-Risk Ratio - all very important to making sure your investment portfolio grows as much as it can without taking more risk with your hard-earned wealth than you would find comfortable.

The Risk Spectrum

Hi there. The Wealth Coach checking in and today I'd like to talk about investment risk. No matter whether your investment portfolio is $5,000 or $500,000, investment risk is a major concern.

There is a mathematical term to describe risk called standard deviation and we'll use those numbers but we'll refer to it as "Risk Factor" here since that term better describes what we are talking about. We have also created a concept that we call the "Risk Spectrum" where you can see where your investment portfolio matches up to whatever else is out there.

The Extremes

For example, over on the safer side of the Risk Spectrum (left hand side) we have U.S. Treasuries with a Risk Factor (standard deviation) of about 2.5%. Over at the riskiest, wildest ride portion of the Risk Spectrum of investments (right hand side) - things like commodities and emerging market equities - The risk factor there is between 30% and 35%. U.S. stocks are at 20-24% Risk Factor (closer to Risky than to safe).

A good investment advisor can lower the Risk Factor by mixing a whole bunch of different asset classes (one's that don't correlate well) into one portfolio. Professional portfolio managers can dial down the Risk Factor to between 12% and 15%. You can go all fixed income and lower the Risk Factor even more, but you do take a serious hit when it comes to expected returns.

Return-Risk Ratio

So that's half the equation, but then we also have the Return-Risk Ratio we need to understand because Risk on it's own means nothing unless it is compared to the returns you expect to get for TAKING that risk. The calculation of the Return-Risk Ratio is pretty simple. We take the expected return of the portfolio and put that number at the top of the equation and then divide that number by the Risk Factor for the portfolio.

Return-Risk Ratio for US Stocks

That Return-Risk ratio comes out like this. For the S&P 500, the expected rate of return is somewhere between 7% and 10%. Historically, it has made 7% returns. I know a lot of people hope that their stock market portfolio will actually make 10%. For the purposes of this calculation, we'll give you the benefit of the doubt and go with the most optimistic number we can find. So let's just say you expect to get a 10% rate of return. The Risk Factor for the S&P 500 about 20%. 10% divided by 20% equals 0.5 which is an optimistic view of the Return-Risk Ratio for U.S. equities.

A Better Idea

On the safer side of the Risk Spectrum we have U.S. Treasuries. Historically, they've made a 4.5% rate of return. I'm going to say that they are not likely to make that kind of rate of return over the next several years so we'll call it a 2.5% expected rate of return with a Risk Factor of 2.5%. Take 2.5% expected return and divide it by a Risk Factor of 2.5% and you get a Return-Risk Ratio equal to 1 - which is much better than a Return-Risk Ratio of 0.5 (for U.S. Stocks).

That's what we do when we are building portfolios for our clients at ALTUS Wealth Solutions - creating portfolios that generate the greatest amount of return for the least amount of risk - and we use this Return-Risk Ratio as our benchmark.

If you have questions on this concept, feel free to call me (805-476-0333) or send me an email ( This e-mail address is being protected from spambots. You need JavaScript enabled to view it ). Until next time, I hope this has helped.

In our next video we'll take the concepts of the Risk Spectrum, Risk Factors and the Return-Risk Ratio and will use them to understand Risk Perception and how it can work against you with your investment decisions.

John