Key Points

  • The typical advisor–client relationship too often ends with a discussion of volatility in absolute returns. Extending the discussion to include a second form of investment risk, tracking error of relative returns, is critical to achieving the best client outcomes.
  • The journey to more compelling investment opportunities and to higher long-term returns is necessarily paved with higher volatility and higher tracking error. A client’s thorough understanding of these bumps in the road will make for more successful advisor–client relationships.


Introduction
Understanding risk and having proper expectations around how it manifests in a securities portfolio is an essential part of making sound investment decisions. All too often, investors and their advisors allow their focus to tilt excessively toward the more positive and exciting side of the coin—forecasting expected returns—while giving short shrift to the more uncomfortable side—evaluating the potential risks. Particularly in today’s environment of quiet volatility,1 investors may be tempted to ignore risk altogether. This is a mistake.

In the first article of our new series, John West and Amie Ko highlighted the pitfalls associated with using historical returns to set future long-term return expectations. In this second article of the series, we examine a concept joined at the hip with returns—that is, the risks investors face in the financial markets.