Risk Adjusted Returns
By Bob Mecca, CFP®, MBA
Vice President of Wealth Management
October 3, 2018
Investors are a bit nervous about this stock market as many have expressed continuing concerns about one or several of the following: our US economy, tariff wars, international issues, terrorism, and politics just to name a few. Anyone of these or combination can torpedo stock investment returns in the short term.
Nearly all investors know that keeping large sums of money in a bank account earning about 2% won’t cut it. With the rising cost of living, making money grow through proper investing strategies is appropriate. Earning total returns higher than the rate of inflation is important. Going it alone without professional help can be unwise.
Our SFG staff devotes significant analysis time evaluating both the macro markets and micro segments. In doing our due diligence, we analyze both return potential and risk. We attempt to produce the best returns over time within each client’s risk parameters. To ignore risk is a recipe for disaster. Consequently, it is appropriate to concentrate on risk adjusted returns which considers the combination of return potential with amount of risk undertaken.
There are various measurements of risk including beta, r squared, standard deviation, Sharpe ratio, Treynor ratio and others. We’ll use a few in our example.
Beta is the measurement of historical deviation movement over time compared to a proper benchmark index. The higher the beta number, the higher the volatility, thus potentially more “risky.”
For example, If investment A has a historical average return over time of 9% with a 1.20 beta and investment B has a historical average return over time of 8% with a .90 beta, then investment B would likely be preferred on a risk adjusted basis.
How? Take the average return and divide by the beta. On a risk adjusted basis, investment A would produce a 7.5% return while investment B would reflect nearly 9%. In an environment of uncertainty, perhaps investors seeking comfort would prefer investment B with a lower actual return but a higher risk adjusted return as exemplified in this example.
Another measure is the Sharpe which measures risk adjusted performance. It measures excess returns by dividing the average by its volatility.
If investment A has an average return of 8% with 10% volatility, the Sharpe ratio would be .8%. If investment B has an average return of 6% with 5% volatility, the Sharpe ratio would be 1.2%. A higher Sharpe is preferred on a risk adjusted basis.
When the stock market is moving rapidly upwards, investors tend to ignore risk adjusted returns and concentrate only on actual real returns. But what about a market with potential issues as discussed above? Should an investor ignore risk? We think not under these present circumstances.
It is proper to update your risk bio profile periodically. Then we compare to your personal parameters including: financial goals, age, emergency funds, upcoming capital expenditures, time horizon for investing, and other factors as needed. Then proper diversified strategies are implemented.
Finally, we actively monitor and study key issues closely on your behalf. When necessary, we make adjustments accordingly.
Thanks to Brad Rathe for his contributions to this article.
Unless otherwise expressly indicated, the opinions or views expressed in this article are the author's own and do not reflect, and may differ from, the opinions or views of Strategic Financial Group, LLC or others within Strategic Financial Group, LLC, including its officers, managers, owners, employees or other service providers.