You may well ask: “I got the return I got. What does risk matter?”

But risk DOES matter. It matters because, if you considered risk, you may have been able to get a higher return. Lower risk is directly exchangeable for higher return unless you are a gambler and not concerned about risk at all.

There are two ways the exchange of risk for return can take place. Let’s use a simple example to illustrate both approaches. Both of these assume that each individual investor has established a suitable level of risk for their portfolio. Here, risk is measured by standard deviation—the amount by which most actual returns varied around the average return over a period of time; the higher the standard deviation, the greater the volatility of return and, therefore, the greater the risk.

First Approach: Borrowed Funds
The first approach uses borrowed funds—margin. Assume that both the market (S&P 500) and Portfolio A have the same expected rate of return: 12%. Also, assume that the S&P 500 has a risk level (standard deviation) of 0.18, while Portfolio A has a risk level (standard deviation) of 0.12. If your suitable risk level is 0.18, then you can simply put 100% of your money in the S&P 500 index and have your return of 12%.

However, you could also buy 150% of Portfolio A and have a risk level of 0.18—you would put 100% of your own money in Portfolio A, plus you would borrow an additional 50% and put it in Portfolio A. In this case, your return would be 12% on the original investment, plus 3.5% on the additional 50%, for a total return of 15.5% [The additional 3.5% is calculated by taking 50% of the return on Portfolio A less a 5% cost of borrowing: 50%(12% – 5%).]

In this instance, the lower risk of Portfolio A was directly converted into a higher rate of return by increasing overall portfolio risk through the use of borrowed funds to increase the investment in stock.

Second Approach: Stocks and Treasuries
Not everyone is comfortable with margin, and in many cases individual investors do not want the risk level of an all-stock portfolio. In that case we can look at the conversion another way, once again using the S&P 500 and Portfolio A.

If you invest two-thirds of your portfolio in an S&P 500 index fund returning 12% with a risk of 0.18 and one-third of your portfolio in short-term Treasuries yielding 3%, with a risk level of zero, your portfolio will have a risk level of 0.12 (2/3 of 0.18 plus 1/3 of 0.00) and a return of 9% (2/3 of 12% and 1/3 of 3%).

However, for that same level of risk, 0.12, you could also invest 100% of your money in Portfolio A, and you will get a 12% return. In this case, adjusting your asset allocation allows you to convert risk reduction into increased returns by investing the portfolio in an all-stock portfolio rather than a mix of stocks and Treasuries.