What Is Your Risk-Adjusted Return?
The markets have soared over the last years and significantly over the last months and it’s tempting to look at the increasing rate of return and get excited, and maybe a bit greedy too. But remember, what goes up must come down. If your portfolio is only built to ride the highs, what’s going to happen when the next downturn occurs? Will you have anything to get excited about then?
By definition, investment risk is “the probability or likelihood of occurrence of losses relative to the expected return on any particular investment.” (1) Put simply, the lesser the investment risk, the lower should be your expected return. However, the rule of thumb is that the higher the risk, the higher the expected return and potential losses. While it’s incredibly tempting to play the market, an important factor in preserving your wealth is to understand risk, especially your own personal risk tolerance. Take a look at how playing the market can hurt you:
“My Name Is John And I Am A Recovering Stock Market Performance Chaser”
John is a do-it-yourself investor and has always been convinced that he is doing a great job at investing. The problem is, he is a self-proclaimed stock market performance chaser. When the market goes up, he gains a lot, and when the market goes down, he loses a lot. He doesn’t really pay much attention to risk and doesn’t really know what the concept of returns adjusted for risk really means.
The truth is, achieving a 5%, 8%, or 12% return doesn’t mean much without taking into account the risky actions John took to achieve these returns. Achieving 12% during a year but running the risk of losing just as much won’t help him build wealth for the long-term. John is paying too much attention to the “trees” and not keeping his eyes on the “forest,” the big picture of his finances and his goals. He thinks he is successful because he got some nice returns on a few exchange-traded funds (ETFs).
Ignorance Is Not Bliss
Ignoring risk doesn’t make it go away. In reality, it may make you take more risk in the future to offset the losses that your behavior caused in the first place. Suppose that John started the year with $100,000, but unfortunately lost 12%, leaving him with $88,000. As you can see in the table below, John will need a 13.64% return the following year to bounce back from his losses.
Why should John do a better job of controlling risk? Doing well when the market is up is great, but doing better when the market is down makes a significant difference over time. Better risk control may help you achieve your goals, despite what the market is doing. A portfolio with proper risk control may seem invisible when the market is up, but it works to your advantage when the market hits a slump.
An Unseen Risk
As if market fluctuations weren’t enough, there is an overlooked risk in the stock market these days. As a reminder, the S&P 500 is currently trading at a record high of 23.49 times trailing-twelve-month earnings compared to a long-term median of 15. (2) At this level, prospective returns are at tremendous risk. On the other hand, the Volatility Index, or investor fear gauge, is currently trading at a very low level, meaning that investors believe everything should be fine for the next thirty days. This attitude of complacency and lack of fear does not bode well for our portfolios.
Nobody can predict the future, but investors should be bracing for turbulence going forward, given the low margin for error that is carried by the current market valuation level. Not only are stock indexes richly valued in the U.S., but the geopolitical risk is also significant. A downside surprise usually depends on an external shock, and we all know how quickly a good time can go bad. And if you believe the correlation between World indexes have decoupled, think twice. In a time of stock market dislocation, correlation may move quickly toward one.
Performance Isn’t Everything
As tempting as it may be, don’t be lured by performance. Most often, relative performance chasers such as mutual fund managers, pension funds, and ETFs have no choice but to participate in the high-flying market, despite the risk.
As an individual investor though, you have no reason to perform like your peers, compare your return to a benchmark, or participate in an overpriced bond or stock market. Your only goal should be reaching your own long-term financial objectives and targeting absolute return, therefore preserving your capital. It is always fascinating to watch the stock market pendulum swing from fear to greed.
Words Of Wisdom
Just a few reminders from savvy investors:
Markets usually change when beliefs change, not fundamentals.
At the right price level, high-risk assets can be safer, and at the wrong price level, high-quality assets can be riskier.
We should worry more today about losing money (being defensive) than about missing opportunity (being aggressive).
Don’t be afraid of increasing cash (cash is not just an asset class that is returning next to nothing; it is a call option with no restrictions attached).
A Better Option
At Montag Private Wealth, we believe achieving good returns with less risk (risk-adjusted return) is the way to preserve capital and achieve absolute return.
Take a look at these numbers:
As you can see in the table above, in both scenarios, the returns are the same at 7%, but the risk-adjusted return of portfolio B is more impressive than portfolio A. Less risk has been taken to achieve the same return. It is easy to see that portfolio B offers the most desirable results. How can you make sure your portfolio is set up for success?
Risk is different for every person based on their unique situation, stage of life, and personality. In light of where the market sits today, many investors are reassessing how comfortable they are with market risk, especially as they draw closer to retirement. They often ask themselves if they are willing to take on as much risk as they were 10 or 20 years ago or if their portfolio accurately reflects their risk tolerance. If you want to understand your personal risk preference and ensure that your portfolio and risk level align, book an appointment now! At Montag Private Wealth, we are happy to provide a second opinion on your investment portfolio with no obligation. We will review our philosophy and our investment approach with you and make our recommendations so you are in a better position to make informed decisions with your money.
Carl Martel is the president and portfolio manager of Montag Private Wealth. Along with more than 15 years of capital market experience and 10 years of experience in real estate hard assets, he is a Chartered Investment Manager® and holds a Certificate in Derivatives Market Strategies from CSI Global Education, a Masters of Science from Laval University, and an MBA from l’Université du Québec à Montréal. A focused and pragmatic, results-oriented investment professional and entrepreneur, he specializes in serving the unique financial needs of high net-worth individuals and families, foundations and endowment funds, and business owners. To learn more, visit http://montagprivatewealth.com/ or connect with Carl on LinkedIn.