Capital Market Assumptions - Part II
Standard Deviation and Risk Capacity
Once we have established the asset classes to own among US and foreign stocks, high quality bonds, and commodities or publicly traded real estate, the next step is to identify the mutual funds or ETFs with low expense that correlate most perfectly.
And this is where the integration becomes more complicated. Each fund will fluctuate in value – and that volatility is measured as standard deviation. In that context, the question becomes: how wide is the historical range of investment returns? The wider range, the higher the standard deviation – and in quantitative terms, the greater the risk.
Not only does greater volatility mean greater market price risk and potentially higher returns, but it could also mean lower volatility and higher relative returns for your investment accounts if the price fluctuations are in opposite directions. That is the “free lunch” of diversification, but it’s easy to mess up with traditional “best practices.”
In other words, we want a very high correlation with the asset classes you intend to own, but low correlation among the funds we own – especially during large deviation events known as “corrections” and crashes. It is not rocket science, but macroeconomists, global strategists, certified financial analysts, institutional money managers, and registered investment advisors have a knack for screwing this up with their “overdiversification.” This happens when the product is the portfolio.
Getting back to standard deviation and asset class returns, in normal bell curve distributions, about 68% of investment outcomes fall within one standard deviation of the median return. And to objective investors, what happens within that range of possibilities is measured and monitored, but not of the greatest concern.
To more fully understand the irrelevance of traditional thinking, consider this from statistician and futures market trader Nassim Taleb,
Almost everything in social life is produced by rare but consequential shocks and jumps; all the while almost everything studied about social life focuses on the “normal,” particularly with “bell curve” methods of inference that tell you close to nothing.
Standard deviation is a statistic, and like money itself, it is a tool that requires the context of an objective investor. First, it must be integrated with correlation - and then applied to your cash flow expectations. With these variables plus life expectancy, we can then calculate your risk capacity and spending capacity. To learn more, please click the link below:
https://www.amazon.com/Moneyball-Method-Middle-Class-Manifesto-Objective/dp/1696009111/