Risk-adjusted Returns
You want the best returns for your money relative to risk. This is true no matter how much or how little risk you are willing to take. It’s universal, intuitive, and not complicated. It goes beyond finance to all areas of our lives. As individuals, we look to maximize our benefit for any amount of risk we are willing to take. When we think about our money, we simply want the best risk-adjusted returns.
In the field of finance, a few academics came up with an equation or two to describe & model this. They generally intended for their work to better explain the risk:benefit tradeoff.
But the big financial institutions love this stuff. They package it up with some glossy pics & a few charts and send it along to investors. It looks & sounds more impressive that way. Unfortunately, it can sound intimidating as well. If you hear terms thrown about & want to check how helpful they are to you, ask the person using them to explain them. When it comes down to it, just know what you want: The maximum available return for the amount of risk acceptable to you.
Depending on how much effort an investor wants to put in, there’s much to be gained from understanding some of the basic concepts of managing risk. Investors should take this to the level they’re comfortable. Taking 1-2 hours to understand the basic concepts of Modern Portfolio Theory, Capital Asset Pricing Model (CAPM), and Sharpe ratio can be quite helpful.
Measuring Risk-Adjusted Returns
So, how might an investor get risk-adjusted returns information on their accounts?
It’s very easy to find out how a particular stock is performing relative to a major index. Company managements are commonly measured based upon this comparison. So, why not for financial managers?*
What you’ll find is that most traditional institutions focus on marketing to you. But, is talking to you about trust the same as building trust? Does repeating the words cautious & conservative mean these are not the same firms that almost went bankrupt in 2008?
If brokers at the traditional institutions had to sit down & discuss performance vs relevant benchmarks each time they met with an investor, a few things might happen: 1) Clients might demand better performance. 2) Clients might ask if the person across the table was an advisor or a salesperson. 3) A great deal of money might find a new home.
If you are currently with an advisor who won’t provide risk-adjusted returns information on your accounts, you might consider why they won’t do it. If the results are there, the effort on their part is certainly justified. But, if they choose not to present this information, that may mean you wouldn’t like the answers it provides.
When looking at performance be certain to compare properly. For example, depending on your source some funds’ return data is given before taxes, sales charges, and fees. Be certain to compare “apples-to-apples” to find the best manager possible for your money.
At Sewickley Financial, we encourage investors to measure returns on a risk-adjusted basis. You can find more detailed information under the Performance Metrics tab.
* It looks easy to analyze performance information for a mutual fund. But understand that many presentations relative to an index may not reflect taxes, fees, and sales charges. It’s confusing at best on many 3rd party websites. Unfortunately, reality includes taxes, fees, and sales charges. If your source doesn’t state how the performance is reported, it might be best to assume no taxes, fees, etc have burdened the presentation.