What is Risk-Adjusted Return?

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 Return?

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 Return?

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 benchmark.

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 performance perspective.

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.

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