Know Your Risk Floor

In times of market turmoil we often hear the advice to “stay the course.” Nervous investors may follow that good advice, but continue to ask themselves “how long should I stay the course?” Another good question is: How do I know I am on the right course? Wouldn’t it be nice to focus on one number? As long as the portfolio is performing better than X, we continue to “stay the course.”

X equals the Risk Floor.

Sounds great, but how do we determine the Risk Floor™? The good news is that determining one’s Risk Floor requires simple math and a basic understanding of chance. What do we mean by “a basic understanding of chance?” Chance is the probability (the odds) that something will or will not occur. The Risk Floor relies on a 95% probability that a portfolio will not fall below a loss of X%. There is always the chance of a loss greater than X% (a 5% chance). How do you feel about a 95% chance that something will or will not occur?

The math is very simple and the sources of information are many. For example, we will determine the Risk Floor for one mutual fund. To do the math we need two numbers: (1) the average (or mean) annual return, and (2) the standard deviation. Clicking on the “risk” tab at a popular free financial web site we find our two numbers: (1) the average (or mean) annual return is 9.05%, and (2) the standard deviation is 10.48%. To determine the Risk Floor, simply multiply the standard deviation by 2 (10.48% X 2 = 20.96%) and subtract that number from the average (or mean) annual return (9.05% - 20.96% = -11.91%). The Risk Floor in this example is -11.91%. This fund should not lose more than -11.91% per year 95% of the time.

Another good question is: What about the upside? Simply add the standard deviation multiplied by 2 (10.48% X 2 = 20.96%) to the average (or mean) annual return (9.05% + 20.96% = 30.01%). There is a 95% chance this example mutual fund’s annual gain will be as high as 30.01%. There is a 5% chance the annual gain will be greater than 30.01%. Therefore, on an annual basis, the return range of this example mutual fund is 30.01% to -11.91%. In other words, there is a 95% chance this example mutual fund’s annual performance will be between a 30.01% gain and a -11.91% loss.

The same concept can be applied to a portfolio of mutual funds. If the investor can tolerate an annual range of 30.01% on the upside and -11.91% on the downside, we have “the right course.” If a -11.91% Risk Floor is “too much,” the portfolio can be re-designed to reduce the potential loss. This portfolio re-design will also affect the upside potential. For example, if the portfolio’s Risk Floor is reduced from -11.91% to -5%, the upside potential may also be reduced from 30.01% to 23.10%, producing an annual return range between a 23.10% gain and a -5% loss (95% of the time).

My advice: Contact your financial planner and work together to determine your Risk Floor.

Know Your Risk Floor

Know Your Risk Floor