What if a portfolio manager told you his portfolio was averaging a 25% annualized return over the past 3 years? That sounds pretty good. He is handily beating the market returns. Do you want him as your investment adviser?
My answer to that question is possibly. I can't really be sure, because he has only told me half the story - the half about the rewards he is reaping. He hasn't mentioned anything about risk. Risk is an important piece of the story, but unfortunately it is also complex, and most people don't understand it.
I am going to explain some things about investment risk, but first I'm going to tell you something else that is easier to understand so you can see the importance of knowing the other half of the story.
Do You Know Jack?
Jack went to Las Vegas, and when he returns he tells you that he won $5,000. You are intrigued. Winning $5,000 is a much better result than most people get in Las Vegas. Perhaps Jack knows some things about gambling that you would like to know in case you ever take a trip to Las Vegas. So you ask Jack how he did it.
"Easy," says Jack, "I found a guy who was willing to bet on a coin flip. We made the bet, I won, and he paid me $5,000."
Jack's story is starting to look a little less interesting at this point, isn't it? Guessing right on a coin flip really isn't a skill you can capture for your next trip to a casino. Jack doesn't seem to have any real gambling skills, he was just lucky. Good for him, but it's not really something to brag about, is it? "So, you just bet $5,000 on a coin flip?" you ask.
"Oh no," says Jack, "HE bet $5,000 on the coin flip. I bet $12,000. But I won, so it was a good bet."
Jack bet $12,000 against $5,000 on a coin flip. Now we can see that Jack isn't just lucky. He is a lucky fool.
He is a fool because the reward he received was not worth the risk that he took. He had a 50% chance of losing $12,000 and a 50% chance of winning $5,000. It is a situation where it is easy to see that Jack took more risk with his money than it was worth. He was lucky - he won - but that does not make it a good bet.
All Investing Carries Some Risk
Let's get back to our portfolio manager with the 25% annualized returns for 3 years. All investing carries some amount of risk. Our portfolio manager has told us he has captured a good reward - 25% annually - but he has not told us how much risk he took to capture that 25% return. We cannot know if investing with him is a good idea until we know if it is worth the risk.
Unfortunately, as I said, portfolio risk is much more difficult to quantify than the simple betting scenario with Jack. It is more difficult to understand, but just as important to making sound investment decisions. Trying to explain how to calculate investment risk in a single article would not be possible (not to mention boring and confusing). Suffice it to say there are numerous sources of risk in a portfolio. Some can be reduced with diversification and asset allocation. Others can only be reduced by not investing at all.
One of my duties as an investment adviser is to manage risk on behalf of my clients. There are two parts to this. The first part is that I need to make sure the amount of risk in your portfolio is reasonable for the rewards we expect. I accomplish this through diversification. The second part is that I need to make sure the amount of risk is suitable to the client's situation, needs, and desires. I accomplish this by getting to know each client and their situation. There are no shortcuts to this. It takes a little time.
If your financial planner has never explained this to you, ask them why.