Investment advisors often use standard deviation as a measure of risk. Standard deviation measures how much a security's returns fluctuate around its average return. A higher standard deviation indicates a more volatile security, while a lower standard deviation indicates a less volatile security.
Return, on the other hand, is the total percentage gain or loss on an investment over a period of time. Return can be measured in a variety of ways, such as annual return, compound annual growth rate (CAGR), and total return.
Why is risk more repeatable than return?
Risk is more repeatable than return because it is based on the historical volatility of a security's returns. This means that we can make a relatively accurate prediction about how much a security's returns will fluctuate around its average return in the future.
Return, on the other hand, is more difficult to predict because it is influenced by a variety of factors, including market conditions, economic growth, and company performance. This means that it is more difficult to make accurate predictions about how much a security's return will be in the future.
Examples of how 10 year CAGRs can vary dramatically over rolling timeframes despite the standard deviation being comparable
The following table shows the 10 year CAGR and standard deviation of the S&P 500 index for different rolling timeframes:
Rolling Timeframe 10 Year CAGR Standard Deviation
1948-1957 20.1% 17.8%
1958-1967 11.3% 19.1%
1968-1977 5.8% 15.4%
1978-1987 17.1% 18.3%
1988-1997 16.9% 16.6%
1998-2007 9.8% 17.5%
2008-2017 13.8% 15.3%
2018-2022 10.0% 16.5%
As you can see, the 10 year CAGR of the S&P 500 index can vary dramatically over rolling timeframes, even though the standard deviation is comparable. This is because return is influenced by a variety of factors, including market conditions, economic growth, and company performance.
What does this mean for investment advisors?
Risk is more repeatable than return, especially in the short term, and investment advisors should be aware of this. This means they should concentrate on assisting their clients in developing diversified portfolios that can withstand market volatility.
Investment advisors should also be aware that the 10-year CAGR of a particular investment can vary dramatically over time. This means they should avoid setting unrealistic expectations for their clients and should emphasize the importance of long-term investing.
Because risk (standard deviation) is more repeatable than returns, the iQ Portfolio Optimizer prioritizes it when creating investment portfolios. If you build portfolios based on a historical return target, your process is flawed