Risk Management – Building Wealth, not Risk
In order to build real wealth over time, it is critical to reducing the amount of volatility in your portfolio. Take the following example:
|Year 1 Return||Year 2 Return||Average Return||Compound Return||Value at End of Year 2|
Source: Dimensional Fund Advisors
Notice how the average return in both Portfolio 1 and Portfolio 2 is the same, but look at the difference in the compound return and end dollar value of these portfolios.
As you can see, volatility plays a significant role in determining a portfolio’s compound return, which ultimately affects value. That is why portfolios should be designed to specifically reduce volatility. By doing so, an investor can receive a higher compound return and greater wealth at the end of the day.
Asset allocation is the best strategy to reduce overall portfolio volatility since the asset classes perform differently. In fact, if a very volatile asset class is added to the allocation, and its returns are not correlated with the other asset classes, the overall volatility of the portfolio may actually be reduced.
Managing volatility is particularly crucial during a market downturn. After the recent bear market in 2008, investors who had properly managed risk have, for the most part, recovered. Others who suffered large losses may never recover.