What is Financial Risk and is it Quantifiable?

For most of us, when we think of the word risk, we think of losing money. We think of the unknown and what could go wrong.

Have you ever heard of the term standard deviation? It may be the measure that you are looking for to assess the overall volatility of your portfolio and your financial risks. It measures how widely portfolio values fluctuate around an average value. The larger the difference between the closing value and the average value, the higher the standard deviation.

So where is the financial risk? If your portfolio value goes down and you need the money, you are forced to sell at a low point.

Remember the bell shaped curve from junior high school? It can help us understand the fluctuations of a portfolio with regard to standard deviation. 99% of the time the fluctuations will be within three standard deviations of its average value, while 95% of the time it will be within two. 68% of the time the fluctuations will be within one. The smaller the standard deviation, the more the fluctuations will stay closer to the average.

So how much of a standard deviation should your portfolio have? That depends on your appetite for financial risk. The Vanguard S&P 500 stock index fund has a 10 year average deviation of 15.82% (as of 5/31/2011, source Morningstar). The Vanguard Total Bond Market Index Fund has a 10 year deviation of 3.79% (as of 5/31/2011, source Morningstar).

Most people think that the lower the standard deviation is, the lower the expected return may be. But that is not always the case. Can we actually make more money in our investment portfolios by taking less risk?

The answer is... most of the time. It's all about correlation -- a statistical measure that tells us the degree to which two things move in the same or opposite direction. A correlation of +1 (perfect correlation) means that two securities move in tandem with one another - in the same direction. A correlation of -1 means that two securities move in exact opposite directions to one another.

As we introduce asset classes that have different correlations to one another, we begin to benefit from the true meaning of diversification. All of our assets don't move in tandem and this helps reduce big losses.

Think of the 500 point drop we had in the Dow Jones on Monday, September 15th. Stocks went down but U.S. Treasuries went up. If you owned U.S. Treasuries on Monday, the negative performance of stocks was truncated by the positive performance of Treasuries. Different types of assets share relatively different correlations with one another, whether positive, negative, or neutral.

Many investors think they are diversified by owning US and foreign stocks. But the correlation of these types of investments can be highly positive, giving people little sense of diversification.

Try constructing your portfolio to be like an orchestra. Instead of owning a guitar, violin, bass, and cello - all from the string family -- consider having a piano, the drums, a saxophone, a guitar, and a singer. You'll have a portfolio that won't be as volatile, making the ups and downs less bumpy, and without sacrificing your expected returns.