This is the time of year when many people are reviewing their investment performance reports from the year before. During this review, however, most people neglect to analyze one of the most important components of their performance: risk-adjusted returns, or RAR.
This might sound complicated, but it’s based on a simple concept: You should view your investment returns through the lens of how much risk you took with each investment, instead of on an absolute basis. Different investment funds take different levels of risk, so looking at return without considering risk provides an incomplete picture, at best.
RAR Helps You Control Investment Risk
Looking at RAR instead of just absolute returns can help you avoid investing in a manager that is taking on a more risk than you might be comfortable with. One risk-adjusted measurement is the Sharpe ratio, which uses a fund’s standard deviation to define risk. Simply stated standard deviation is an investment’s volatility of returns relative to its average return. A higher standard deviation implies a greater dispersion of returns, where as a lower standard deviation translates to a more concentrated return pattern.
The Sharpe ratio is determined by dividing a fund’s absolute return minus the risk-free rate by the standard deviation. The risk-free rate is the return of an investment with no risk associated with it such as the yield on a Treasury bond. The higher the resulting number, the better.
Return - Risk-Free Rate / Standard Deviation = Sharpe Ratio
Another way to measure risk-adjusted returns is to calculate a fund’s Alpha. As opposed to measuring risk using standard deviation like the Sharpe ratio, a fund’s Alpha is calculated using beta. Beta is a fund’s sensitivity of returns compared to a relevant benchmark or index. So if a fund’s beta is 1.2 and the market (benchmark) rises 10%, then the fund is expected to rise by 12%. If a fund’s beta is .8, then the fund is expected to rise by 8%. An investment’s Alpha is the difference between the actual return and the expected return when adjusting for beta. Using the above example, if the expected return of a fund was 12 percent and the actual return was above 12 the fund experienced positive Alpha, however, if the return was below 12, the fund had a negative Alpha. Obviously, positive Alpha is preferred.
Return – [Risk Free Fate + (Market return – risk free rate) Beta] = Alpha
When measuring a risk-adjusted return time periods are important. A short time period like one-year is often too short to be considered relevant. It is often times preferred to look at three-, five-, ten- or fifteen-year time periods.
How Risk-Adjusted Returns and Market Performance Are Related
If an investment takes on more risk than the market or benchmark, you should expect higher returns when the market is moving higher. The opposite is also true: If an investment takes on less risk than the market or benchmark, you should expect lower returns during strong markets.
When monitoring your investments, you should consider risk and current market conditions in your analysis. It should be noted that, over some time periods less risky or volatile areas of the stock market outperform the more volatile sectors of the stock market but over a full market cycles the investments that produce more volatility (take on more risk) tend to outperform.
But this doesn’t necessarily mean that you should always take on more risky investments in order to beat the market over a full market cycle. If you own a more conservative investment strategy you should expect to lose less when markets fall which means you might not need to return as much on the upside. For instance, if you lose 50 percent on the downside you will require a 100 percent return to get back to even but if you only lose 30 percent on the downside you only need to earn around 43 percent to get back to even.
The right strategy for you should be determined by your risk profile, which is based on such factors as your age, investment time horizon, investment goals and comfort level with market volatility. This is different for every individual and something you can only gauge for yourself.
RAR Can Help You Select and Monitor Your Investment Portfolio
Every investor should have a process for selecting investments and we believe looking at risk-adjusted returns should be part of the criteria. Before adding an investment to your investment portfolio, you should look beyond absolute returns and look at many other considerations including risk-adjusted returns.
When monitoring current investments, looking at RAR, as opposed to just absolute returns, you may be able to avoid terminating a good investment simply because absolute returns were below a given benchmark.
Final Thoughts on Why Risk-Adjusted Returns Are Important
One thing that is important to point out that has not been addressed yet is that the two risks we mention in this post - beta and standard deviation - are more reflective of volatility and not permanent loss risk. Even though market volatility may not reflect a permanent loss, many investors make investment decisions based on investment fluctuations which makes these volatility measurements relevant.
At ACG, our manager selection process focuses on managing risk, which in many cases leads us to less volatile investments but good risk-adjusted returns. If you have more questions about our approach to risk-adjusted returns, please give us a call.