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Minimize Your Risk
Without Lowering Overall Returns
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Published:
March 3, 2008
As much as we would
like the market to steadily increase
and make us rich in the process, we
know that this can't always be the
case. Every once in awhile the
market goes through a period of
increased volatility. Marked with
uncertainty, these times are filled
with sudden twists and turns that
are enough to make
even the most hardened market observers a little dizzy.
When the waters become increasingly choppy, you might be
wondering if there's anything you can do to keep your portfolio
on an even keel, short of stuffing money under the mattress.
After all, risk and reward always go hand in hand. Yet, that
doesn't mean that you can't take steps right now to help keep
that risk to a minimum -- while leaving your expected rewards
unchanged.
The Road Less Traveled
Most of us naturally gravitate toward funds that have produced
superior historical returns. However, not everyone stops to
evaluate just how much risk shareholders were subjected to in
order to achieve those returns.
For the sake of illustration, consider a fund that delivered
stable returns of +8% in 2005, +8% in 2006, and +8% again in
2007. Now, imagine another fund that posted a gain of +6% in
2005, a loss of -2% in 2006, and then a gain of +21% in 2007.
Both would have turned a $10,000 investment into nearly $12,600
over the three-year period, for a cumulative gain of +26%.
However, which of the two would you rather own? Most likely you
would take the first, because it provided a much smoother path
to the exact same destination.
Of course, in the real world it's unrealistic to expect to
encounter such a choice. But the underlying premise remains the
same. If two funds with similar fees and
portfolio composition provided the same returns, but one took a
more direct route and experienced narrower price swings along
the way, then it is probably your best bet.
Reading the Fine Print
While it only makes sense to avoid overly volatile funds, in
practice many investors don't even bother to conduct more than a
cursory background check -- looking up historical returns is
easy; evaluating risk metrics can be trickier. However,
it only takes a few minutes to get a grasp on the basics --
which are explained in plain English below.
When attempting to mitigate the impact of a volatile market,
carefully consider each of the following:
Beta -- Beta is a useful way to gauge volatility and determine
whether or not a fund moves in tandem with an underlying
benchmark. A beta of 1.0 means a fund marches perfectly in
lock-step with the benchmark index, while anything above or below 1.0
implies the fund typically moves faster or slower. For example,
a fund with a beta of 0.5 against the S&P 500 is generally
half
as volatile as the index and can reasonably be expected to drop
just -2% in a period when the market loses -4%.
Keep in mind, a properly diversified portfolio has little to do
with the number of funds inside it, but rather the way those
funds work together. Whenever one group of securities is moving
down, there should be another somewhere else that is moving
sideways, or even up. Evaluating fund betas and holding a
variety of different asset classes with low
correlation can be a great way to smooth out the inevitable
bumps in the market.
Standard Deviation -- Standard deviation is another widely used
measure of volatility. Essentially,
standard deviation tells us how widely a security's returns are
scattered around its average return. Clearly, a fund that is up
+40% one year and down -22% the next is more volatile (and thus
has a higher standard deviation) than one that gains +12% one
year and loses just -6% the next.
But remember, different asset classes will have different
standard deviation ranges, so it's important to compare figures
from within the same category. As a rule of thumb, standard
deviations for small-cap stocks, large-cap stocks and bonds have
averaged roughly 16%, 12%, and 4%, respectively, over the past
five years.
Sharpe Ratio -- The Sharpe ratio is calculated by determining a
fund's excess returns over the risk-free rate (usually the rate
U.S. Treasuries are paying) and then dividing by its standard
deviation.
Any fund can outperform the risk-free rate, but all must take on
a certain degree of risk to do so. By factoring standard
deviation into the equation, we get an idea of not only a fund's
raw returns, but also how the manager has done on a
risk-adjusted basis -- the higher the Sharpe, the more
impressive the performance.
For example, assume that a fund with annualized returns of +14%
over the past three years has a standard deviation of 9%. If the
risk-free rate over this time frame was +3%, then the fund would
have a Sharpe ratio of 1.22. Written out, that calculation would
be: ((14%-3%)/9%).
Generally speaking, any Sharpe ratio above 1.0 is considered good and
anything greater than 2.0 is exceptional.
Alpha -- Alpha is considered by many to be the Holy Grail
for professional money managers and the best barometer of
whether or not they earn their keep. The actual calculation can
be somewhat complex. But in simple terms, alpha captures the
excess risk-adjusted returns that a fund earns above that
implied by its beta.
In other words, alpha gives us an idea of how much of a fund's
returns can be explained by savvy investment decisions, beyond
those that come from just drifting with the overall flow of the
market.
Alpha and beta work hand in hand. As a simplified example, if a
fund's beta is 1.2 relative to the S&P 500 and the index posts
an annual return of +10%, then we can expect the fund to have
delivered a gain of +12%. However, if the actual return was
higher, say +15%, then the manager clearly added value -- and
alpha measures that value.
Think of alpha as a way of measuring "bang for the buck", the
higher the figure, the more value a manager brings to the table
for fundholders.
The Big Picture
Like other financial metrics, risk and volatility measures such as beta and
standard deviation have their flaws and shouldn't be used in
isolation. However, when taken together, these data points can
present an accurate depiction of whether or not a fund's
shareholders are being adequately rewarded for the risk they
have assumed.
While it can be seem complicated at first, risk analysis is a
vital part of the investment process utilized by all successful
investors. And in a recent issue of
The ETF
Authority, editor Nathan Slaughter scoured
the investment universe for securities that provide some of the
biggest payouts for the least amount of risk. In the process,
Nathan found a fund that has returned +1,395% over the last two
decades and another that doubled the S&P's performance over the
last five years -- with roughly the same amount of risk. To learn
more about
The ETF
Authority, including how to access Nathan's profiles
of these funds, please
visit
this link.
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