A topic I haven’t covered in a long time (and, based on a comment left by someone yesterday, some people don’t get ) is risk adjusted return. We have been trained over our investing careers to obsess over portfolio performance when what we should be thinking about is outcomes. Forget the absolute number – will our portfolio do what we need it to do? Pay our bills when we can’t work? Allow us to quit working at 45? Not run out of money before we run out of breath?
This brainwashing has lead us to focus on only one number to the exclusion of all others – return percentage. But you cannot examine return percentage in a vacuum. There are other very important considerations including conflict of interest, fees, and risk. Conflict of interest and fees are a topic for another day but let’s talk about risk.
There are two approaches to risk. One is to ignore it completely (which is what the financial services industry wants you to do) and HOPE it doesn’t bite you in the butt. That sounds like a good strategy, doesn’t it? The second is to manage risk and performance as two inter-related pieces of an equation. This is the way big institutions, foundations, trusts, pension plans, and insurance companies manage their portfolios.
When we focus on performance numbers alone, we tend to focus on THE NUMBER – which is an average return over time. You may hear that a mutual fund has returned 8.% over the last four years, or the stock market has returned 10% over long periods of time. By themselves, those numbers mean zilch.
Do you know why? Because you are never going to be the average!
By definition, when we talk about averages, we are saying that some number of the sample are above that number and others are below. What you want to know is how far above or how far below. This is the definition of risk – the standard deviation of return. In other words, how much variability is there in that return?
So let me just give you an example. If I have a return in a mutual fund of 35%, on first blush that would be good, right? But if I tell you the standard deviation is ±90%, that wouldn’t be so great. That means that 2/3rds of the time, the return would fall between 125% and -55%! That is a massive swing and is by definition a ton of risk. There is no telling where you might end up from month to month, year to year, with a distribution of returns like that!
Now let’s go to the other extreme. Let’s say I had a bond portfolio with a return of 4% and a standard deviation of ±0.2%. Now that would be incredibly safe. You always know what your return is. There is almost no uncertainty there!
If one job of the investor is to make sure that he or she gets the maximum amount of reward for each unit of risk taken, then the appropriate way to view performance is to take the two competing variables – risk and return – and put them together. This is something called risk adjusted return.
Risk adjusted return looks at how much return did you make for each unit of risk that you took on. It can be measured several ways but the most common is something called the Sharpe Ratio. If I look at one portfolio that has returned 15% and another that has returned 13% and all I look at is return percentage, I would think the 15% portfolio was better.
But think again. If the 15% portfolio has a risk level of ±30% and the 13% portfolio has a risk level of ±6%, on a risk adjusted basis, the 13% is actually better than 15% because of the consistency of the return. If you would like to know more about the value of consistency, in absolute dollars, see my post on the Fred Fiasco.
Sycophants of average return numbers seldom talk to you about risk. Show me the statistical measure of the risk in your portfolio from one of the big brokerage firms. But the only way to measure two investments or two portfolios side by side is to compare them on a risk adjusted basis. Otherwise, you are comparing apples to oranges and are likely to fall into the trap of high risk, “here today gone tomorrow” type investments.