Understanding The Risk Of Your Portfolio (January 2005)

Created on Saturday, 01 January 2005 Written by Joe Paoloni

The most recent round of T.D. Waterhouse television commercials ask viewers, ”Do you know the risk of your portfolio?” As I watch these ads, I think, “Yes, I know the exact risk of each of my managed portfolios.” But the more important question is do my clients know the risk of their portfolios? Many clients don’t pay attention to this information and pay me to keep track of their risk.

However, when I watch the Waterhouse commercial, I can’t help wonder how many brokers, bankers, advisors and money managers don’t have a clue what their clients’ statistical risk figures are. My sense is it may be the majority, due to the large number of investors who visit my office facing substantial loss they sustained from their brokers over the last several years.

The problem is that most financial professionals are taught the “pie chart method” of asset allocation—where you assign your dollars based on age, income, and goals to a percentage of holdings in income, growth, aggressive growth sectors, etc. Unfortunately, this marks the beginning of the planning process, not the end. I find most professionals build a pie chart, allocate the dollars, then head to the golf course. With this strategy, their golf score ends up being lower than their clients’ statistical risk figures!

The next time you talk to your financial advisor as him or her the following questions:

What is the overall standard deviation of my portfolio?
The standard deviation figure represents the overall risk of your portfolio compared to that of a given benchmark (S&P, NASDAQ, DOW). For example, if your overall standard deviation is 4.5 and the benchmark’s is 17.2, you can say that your portfolio has 4 times less risk than the market (these figures are based on the S&P 500).

What is the correlation matrix of my portfolio? A correlation matrix represents the true diversification of your assets. Its goal is to smooth out the bumps in the road and strike a balance among all the holdings in your portfolio that will result in a mix that can weather a variety of economic changes and events. Economic occurrences across the globe create spikes and valleys in your portfolio that translate into unpredictable returns. A portfolio with a low correlation amongst funds would have sailed through the bear market of 2000 with a consistent, positive return.

What is the overall mean of my portfolio?
The mean reflects the historical return of your overall portfolio. Past performance is no guarantee of future performance, however, the lower the standard deviation of a portfolio, the more predictable the future returns. I recently spoke to a person that recently changed advisors. He told me the broker had given him a 40% return in the last 12 months. I asked him what the overall standard deviation of his portfolio was. He didn’t know. Without knowing your standard deviation, you can fall into the same pits many investors did in the late 1990s—this means big ups and BIG downs.

If your financial planner does not know the answer to these questions, ask him/her to give them to you. If your financial planner does not know what you are talking about, the most important advice I can give you is simple: “Run!” Below are some other important figures to obtain from your advisor and is an excerpt from a worksheet we’ve created for investors:

Questions You Need From Your Current Financial Portfolio:

These technical questions will answer the following about your portfolio: how diversified you are, how much risk you are taking, your loss potential, and how much return you’re making per unit of risk.


1. What is the R2 factor over three years of your total portfolio?

2. What is the Sharpe ratio over three years of your total portfolio?

3. What is the Standard Deviation of your total portfolio over three years?

4. What is the total portfolio mean of your portfolio over three years?

5. What is the total portfolio Beta over three years?

6. What is the total portfolio Alpha over three years?


Suggested Guidelines:

1. The R2 factor demonstrates mathematically how diversified a portfolio is. This number should be at 50 or below.
2. The Sharpe ratio reflects how much return you’re making for each unit of risk you’re taking. The higher the Sharpe ratio, the more efficient the portfolio is. You want to get twice as much return for every unit of risk you’re taking. So your Sharpe figure should be at least 2 or more.
3. Standard Deviation measures how much volatility is in the overall portfolio. A low standard deviation means low volatility and therefore, more predictability. We recommend it be low—somewhere between 3 and 7.
4. Mean is the overall return of the portfolio over a given period of time. You want a high mean and a low standard deviation. A good rule of thumb is to have a mean at least twice your standard deviation.

*This article is not a recommendation to buy or sell and should not be considered investment advice. Please consult IPS or another financial advisor before making any investment decisions.