Frederick Douglas once famously said “they want the ocean without the roar of its many waters”. His point was that that is not possible to enjoy the beauty of the ocean without accepting the stormy seas that are part of having the ocean. The same is true in investing. You cannot have market returns without accepting the volatility (or roar) that comes with those returns.

At Capstone, we believe one of our greatest services is to try to mitigate some risk through diversification. By adding complimentary pieces to your portfolio, we can try to maximize your return while minimizing your risk. You can mitigate some but not all risk through this process. At the end of the day there is what is known as the optimum portfolio. That is, for a given level of risk, there is a maximum level of theoretical return. You simply cannot have more return without taking a risk of losing more of your principal in a bad market.

Some examples of this risk/reward tradeoff are worth understanding. The risk free rate is what you could expect to earn on an investment while taking essentially no risk of losing money. By definition, this is thought of as a three month US Treasury bill. Currently, the amount you would earn on this type of investment is .03 per cent per year (compare that to the rate of inflation and it is not a pretty picture!). To earn above that rate of return you must be willing to take some additional risk.

To get equity type returns (the risk free rate and a premium for taking the risk of owning equities with unknown future values) involves adding a tremendous amount of risk. Over the long range, stocks have a standard deviation of about 15 per year. That means that if you believe the return for stocks will be 8% per year that 68 % of the time the return will be between -7% and + 23%. To cover 95% of returns would mean your annual return will be between -22% and +38% in a year. Years like 2008 are outside the range of two standard deviations and are even worse.

Most of us who have spent our lives saving and accumulating money so that we can achieve our financial goals are uncomfortable with these levels of risk. Therefore we seek a return on our investment that is somewhere between the risk free rate and the expected rate for equities. We must earn more than the rate of inflation in order to grow our buying power, but….we don’t want to put large amounts of our principal at risk. For us, blending together a great number of asset types gives us the best chance of getting a needed return while taking as little risk as possible.

At Capstone, we try to build portfolio mixes that will work to help you achieve your goals. According to your needs and your tolerance for risk, your portfolio is similar to ordering a salsa-do you prefer mild, medium, or hot? That is an individual decision that you make and is one we assist you with by mixing in the best portfolio ingredients we can find. Together, we try to build a customized solution that is comfortable for you.

By Ted Schwartz, CFP©