The lesson investors need to understand when building their portfolios. To maximize their potential profitability, they must be willing to bear some risk and suffer losses, at least for a while.
But how frequent and profound can these losses be before the risks are no longer beneficial? Analysis of investment funds over the past 20 years shows that risks at the level of 19.5% of the annual standard deviation and 25% of unprofitable years brought the maximum return, while the return on funds with higher (and lower) risk was lower.
This is a vital point. The main objective of a well-diversified portfolio is to provide the appropriate level of return required by the investor, but to do so in a way that minimizes both the frequency and magnitude of annual losses.
Why? Because investors watch and often react badly to investment losses.
The typical measurement of risk is the standard deviation of return, but this is not intuitive for most people. Very few investors calculate the standard deviation of their portfolio, but everyone can probably remember the last time their portfolio had negative annualized returns and even the size of a loss at that time.
It is impossible to build any portfolio without risks, which means it is worth taking risk for granted.
