Many of us who have been actively managing our
investments wants to know how well we’ve performed and if our investment
returns are worth our time and effort. Knowing whether you’ve been doing a good
job can be a challenge for some investors. It’s difficult to define what good
is because it depends on many other factors.
What is Absolute
Typically, investors measure their performance
in terms of absolute return which simply refers to the investment returns of an
asset or portfolio over a certain period.
I mean, how often have you hear a friend
boasting returns like: “I made 30% on AEM holdings in just 2 weeks!”.
I’m sure we’ve heard that a couple of times before.
Unfortunately, absolute return does not say
much on its own. For example, an investor who profited 30% from a stock might
have risked 100% of his capital in doing so. In this instance, the investor
does not have an investing edge as he is constantly risking more than the
potential reward. In other words, he might have just been lucky.
What is Risk-adjusted
Therefore, we must consider how much risk is
involved in producing that return, this is also known as Risk-adjusted
return. In the professional world, Risk-adjusted returns are applied to
individual securities, funds, and portfolios. The methodology is used to
compare the returns of portfolios with different risk levels against a
Some common risk measures include alpha,
beta, R-squared, standard deviation and the Sharpe
ratio. When comparing multiple potential investments, you should always compare
the same risk measures to each different investment to get a relative
The underlying principle in calculating risk-adjusted
return is to compare the investment returns of an asset against its volatility.
A fund that generates a high return on investment with high volatility is
likely to score a low rating versus a fund that generates moderate returns with
very low volatility.
Let’s look at the example above:
In this assumption, the general stock market or
benchmark index in Singapore is the Straits Times Index (STI Index). It yields
an average of 6% yearly with an average volatility of 15% with a risk-free rate
of 3% over the past decade. The STI is compared against 3 investment funds as
shown and these investments are ranked in accordance to their Sharpe ratio. In
this instance, the fund with the highest Sharpe ratio is the best risk-adjusted
performing fund. From the table above, we can see that Fund ABC generates the
highest annual return, yet ranks lowest in terms of Sharpe ratio. This is due
to the volatility of the portfolio as it is the highest among the 4
investments. Thus, from the example above, we conclude that the fund with the
highest annual return might not be the best risk-adjusted investment.
Risk-adjusted returns can have a severe impact
on portfolios. In bull markets, a fund with lower risk than the benchmark can
limit returns, and a fund that undertakes more risk than the benchmark may
experience more sizable returns. Yet higher-risk funds are prone to losses
during volatile periods, but these funds are more likely to outperform their
benchmarks over full market cycles.
How do professional
investors think about risk?
Absolute return and Risk-adjusted return are
commonly perceived as two different schools of thought. However, I would
challenge the general assumption that absolute and risk-adjusted returns are not
mutually exclusive schools of thought.
Absolute returns are often compared against
relative returns, and I think most professional investors would agree with the
old adage, “You can’t eat relative returns”. Though in practice everyone needs
some sort of benchmark against which to compare performance.
I would also confidently assume that most professional investors inherently
think about risk-adjusted returns more of the time. However, over a
sufficiently long track record, the two are generally indistinguishable.
My argument for this is that a solid long-term
track record (over 20 years) cannot be attributed to luck. Thus, if a fund
manager was in fact taking a lot of undue risk in generating his outsized
returns, it’s also likely that at some point he gets unlucky and those
underlying risks manifest in outsized losses.
Take Warren Buffett as an example, his holding
company, Berkshire Hathaway’s market value has compounded at an annual rate of
20.5% vs the S&P 500 at 9.7% from 1965-2018. Over 53 years, that is an
enormous amount of outperformance. The point is that while the absolute returns
are obviously staggering, it is also quite apparent that one could not achieve
that sort of returns over a period of 5 decades without managing risk well.
Warren Buffett and his partner, Charlie Munger
are known for criticising modern financial concepts such as the Capital Asset
Pricing Model (CAPM) and Modern Portfolio Theory (MPT). He claimed to have
never used sophisticated financial models to assess investment opportunities.
In fact, he once explained why the use of beta
is completely pointless to him on which he said, “One quick example: The Washington Post Company in 1973 was selling for
$80 million in the market. At the time, that day, you could have sold the
assets to any one of ten buyers for not less than $400 million, probably
appreciably more. The company owned the Post, Newsweek, plus several television
stations in major markets. Those same properties are worth $2 billion now, so
the person who would have paid $400 million would not have been crazy.
Now, if the stock had
declined even further to a price that made the valuation $40 million instead of
$80 million, its beta would have been greater. And to people that think beta
measures risk, the cheaper price would have made it look riskier. This is truly
Alice in Wonderland. I have never been able to figure out why it’s riskier to
buy $400 million worth of properties for $40 million than $80 million.”
Despite being one of the most prudent and
risk-conscious investors in the world, the statement tells us that Buffett never
used risk-adjusted metrics such as the Sharpe ratio, beta or risk premium model
to make investment decisions.
Why is that so?
Well, professional investors like Buffett
defines risk differently from the theoretical methods taught in business
schools. The finance academia defines risk as ‘price volatility’, the more
volatile a stock price is, the riskier it is perceived. Thus, metrics such as
the Sharpe ratio, beta and standard deviation focuses on historical price volatility
of an asset.
In contrast, Buffett sees heightened volatility
as an opportunity. As a value investor, he is known to take advantage of market
pessimism and volatility to purchase shares of high-quality companies. He can
choose to buy shares at cheaper prices or simply ignore them.
Joel Greenblatt, is a well-known modern-day
value investor with a 20-year track record of generating a 40% annualised rate
of return for his fund, Gotham Capital. Once said “My largest positions are not the ones I think I’m going to make the
most money from. My largest positions are the ones I don’t think I’m going to
lose money in.”
Here, Greenblatt shared that his portfolio
allocations are not based on historical volatility of an asset but rather the
probability of permanent loss. Investors like Greenblatt assess risk
differently, a fundamental investor who have deep knowledge of a company and
its industry would not assess risk by price volatility but rather fundamental
factors like industry and macro outlook of a business.
Here’s an example…
Let’s say you’re investing in a deep value
stock that is priced well below the liquidation value of the company. Does it
make any sense to measure risk by looking at how volatile the market price of
that security has been historically and what it might be going forward?
Obviously not. In these cases, risk should be
thought of as the probability of permanent loss. To that extent, you should be
asking questions like:
What is the
probability of the company going into bankruptcy?
What is the yearly
cash-burn that is expected in the coming 2-3 years?
Will the company
deplete its cash reserve before then?
In this instance, you start thinking about the
distribution of potential returns and whether the overall positive expected value
of the investment is enough to compensate for the possibility of large losses
in your downside.
That informs your views on risk-adjusted
returns for that investment, and you can then size appropriately to curate how
that translates to absolute returns. This should be the entire process of how
one can manage the downside risk of an investment. Consistency in this process
will increase the odds of winning and ability to generate sustainable long-term
returns. Thus, over a sufficiently long period, absolute and risk-adjusted
returns are generally one and the same.
In conclusion, good money managers prioritise
good and robust risk management and understand its importance in building a
long-term track record. Risk management is about managing the worst possible
scenario for your investment and having an action plan if it happens. As retail
investors, we should focus on protecting your capital first and the reward will
take care of itself.
Ruzaini is the founder of theasiancontrarian.com, a deep value focus that provides insights on some of the most undiscovered and undervalued businesses in Asia. With a keen eye for oddball and obscure ideas, Ruzaini seeks to offer an alternative perspective in the investing arena.