Risk, Returns and Reality (2007 FINRA Reviewed)

In everything from your stock portfolio to your morning commute, you constantly face risk. Some risks, such as that of having a car wreck or developing a terminal disease, are able to be forecasted with a high degree of accuracy. But what about the risks to your stock portfolio? Any investor that has lived through a turbulent period such as the tech bust of 2000-2002 or the subprime crisis of 2007 understands the limitations of standard financial risk measures. Unlike rolls of the dice or spins of the roulette wheel, financial risks and returns are not random, normally distributed, or independent from one another. This means that the opportunity for gain or the possibility of loss cannot be modeled very well, no matter what the latest software on asset allocation tells you. In this report, we examine and explain the common risk measurements used in the financial services industry - terms such as “mean,” “standard deviation,” and “correlation coefficient.” We point out the limitations of, and therefore the dangers inherent in, these measurements and also the danger of assuming that stock returns are “normal,” using examples such as the tech bust of 2000-2002, the Long Term Capital Management debacle of 1998, and the great crash of 1987. For investors approaching retirement these dangers are not trivial - they can mean the difference between having a comfortable retirement or watching your nest egg slip away. Read this report to get a better understanding of the risk you truly face as an investor.

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