Understanding Risk and Return

Copyright: <a href='https://www.123rf.com/profile_olivier26'>olivier26 / 123RF Stock Photo</a>Jeff and I believe that it is very important to educate yourself as much as possible about your financial situation, no matter what stage of life you are in. That includes understanding both the risk and the potential return associated with your investments.

Although risk and return are two concepts commonly discussed as they relate to investment portfolios, often times investors do not understand the measures used to assess either. So, I would like to use this week’s article to give you a brief explanation of some of the more common ones.

Cumulative Return: The Cumulative Return of an investment is the total gain or loss of an investment over a defined period of time, measured by the current price as it compares to the initial price. For example, if in year one an investment returns 12%, then in year two it loses 8% and in year three it earns 4%, the Cumulative Return at the end of year three would be 8%. (12% – 8% + 4%). The Cumulative Return can also be adjusted to include the effect of dividends, should there be any. This is a great way to see the actual performance of an investment over time.

Annualized Return: The Annualized Return is the rate of return that would produce the same cumulative return if compounded over the same time period. The Annualized Return is the geometric average of the Cumulative Return. (And for those of you who are not math majors, a geometric average accounts for compounding, whereas an arithmetic average does not.) Annualized Return can also be adjusted to reflect dividends paid. This is a measure that can be useful when comparing two investments that have very different performance time periods. For example, if Company A issues stock twenty years before Company B, Company A has a twenty-year head start for purposes of calculating the Cumulative Return. The Annualized Return can level the playing field in a situation like that.

Although both Cumulative Return and Annualized Return can be helpful in assessing the performance of an investment, neither are very helpful when understanding the volatility associated with an investment. To measure volatility and risk, we can look to other measures.

Maximum Drawdown: Maximum Drawdown measures the total decline in an investment’s value from peak to trough over a defined period of time, before a new peak is attained. Although Maximum Drawdown measures the size of the largest loss, it does not measure the frequency of large losses. Most investors, particularly those approaching retirement, benefit from investments with relatively low Maximum Drawdowns, as this would indicate lower volatility. To give you some perspective, the S&P 500 had a drawdown of approximately 55% from its peak in October 2007 to its trough in March 2009. This is a significant drawdown.

Standard Deviation: Standard Deviation is a measure of the dispersion in a set of data away from its mean (its average). In finance, Standard Deviation is typically applied to an investment’s annual rate of return to measure its volatility. So, the more an investment’s annual return varies from its average annual return, the higher the Standard Deviation, which signifies higher volatility. A lower Standard Deviation typically mean less uncertainty, which is an important consideration for some investors. However, it is important to keep in mind that Standard Deviation does not distinguish between returns that fall above the average from those that fall below the average, so an investment’s high Standard Deviation can be the result of either.

Downside Deviation: Downside Deviation only measures the negative deviation of an investment’s return from its average annual return. It measures the “bad” volatility.

Sharpe Ratio: Named after economist William F. Sharpe, the Sharpe ratio is one of the most popular ways to measure risk-adjusted returns. It represents the added value (or excess return) of an investment compared to the return of a risk-free asset (often represented by the 90-day Treasury Bill). The higher an investment’s Sharpe Ratio, the better its returns have been relative to its added risk. The Sharpe Ratio is calculated by subtracting the risk-free rate of return from the return of the investment being analyzed and dividing that number by that investment’s Standard Deviation.6 A higher Standard Deviation will therefore result in a lower Sharpe Ratio, but as I explained above, Standard Deviation accounts for both upside and downside volatility. So, an asset with a high Standard Deviation, even if due significantly to positive deviation, may result in a lower Sharpe Ratio.

Sortino Ratio: While the Sharpe Ratio uses Standard Deviation to measure risk-adjusted return, the Sortino Ratio (named after economist Frank A. Sortino) uses Downside Deviation to measure risk-adjusted return. It is calculated by subtracting the risk-free rate of return from the return of the investment being analyzed and dividing that number by the investment’s Downside Deviation.7 In other words, only “bad” volatility will affect the Sortino Ratio. Just like with the Sharpe Ratio, a higher Sortino Ratio is better, as it indicates that the investment is returning more per unit of negative risk that it assumes.7

It is always important to keep these numbers, as well as other risk and return measures, in perspective and to understand their limitations. When looking at both Cumulative Returns and Annualized Returns, understand the nature of the assets you are comparing and remember that these numbers do not reflect the volatility or risk associated with those assets. When looking at Maximum Drawdown, be aware of the time frame included and consider whether or not the markets have seen significant volatility during that time frame. For example, if a mutual fund began in 2010, the Maximum Drawdown would probably be significantly different than it is for a mutual fund that began in 2005. Remember also that Standard Deviation and the Sharpe Ratio take into consideration both positive volatility and negative volatility and do not factor in the timing of those returns. Lastly, remember that for Downside Deviation and the Sortino Ratio to be useful, there must be sufficient negative data. So again, like with Maximum Drawdown, consider the time frame used to calculate these measures.

As Jeff often says, we don’t think of specific strategies as good or bad, but instead appropriate or inappropriate given our goals. We hope that this information will help both our clients and you, Cutter Family Finance readers, to make informed decisions so that your strategy is appropriate for you.

As Jeff always says, be vigilant and stay alert, because you deserve more.

Susan Roman is an Investment Advisor Representative at Cutter Financial Group, LLC. A wealth management firm with offices is Falmouth, Duxbury, and Mansfield. Susan can be reached at susan@cutterfinancialgroup.com.

Cutter Financial Group LLC (“Cutter Financial”) is a SEC Registered Investment Advisor.

This article is intended to provide general information. It is not intended to offer or deliver tax, legal, or investment advice in any way. Information regarding investment services is provided solely to gain a better understanding of the subject or the article. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy will be profitable. For tax or legal advice, please consult a qualified tax professional or legal counsel.

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