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Risk-Adjusted Return

Updated 05/14/14

customer.gif (2751 bytes)If you want to find out whether any given fund has good management,  compute the fund's expected risk-adjusted return and compare its actual return Over the long-term,

  • For every unit of risk that you take, you should get a unit of return.
  • More risk should = More return.
  • Less risk should = Less return.

This is true for most mutual funds, but less applicable to stocks, Well managed funds have more return than expected. Poor funds take too much risk to get their return.

Risk-adjusted return requires that you establish the context
  • Extreme High Risk: The risk that you will lose all your investment in a $1 lottery ticket while trying for the $150 million Power Ball Jackpot a near certainty thus risk-adjusted return cannot be meaningfully calculated. Gold funds, and many stocks, also have extreme risk levels for which risk-adjusted return cannot be calculated.

  • Extreme Low Risk: With a passbook savings account, risk of loss is extremely small, but there is still return. Therefore risk-adjusted return cannot be calculated. Money market and ultra-short term bond funds also have little or no risk therefore risk-adjusted return cannot be calculated.

  • Middle ground: For most investment grade, blue chip stocks, most bond funds, and all stock mutual funds, FastTrack can predict return based on volatility measured by Standard Deviation (SD=).
Predicting return using the White Line

The chart shows a yellow S&P-500 fund, VFINX. For this chart, VFINX is selected as the "Standard Risk Basis" for all US Equity funds. The green line, FBNDX, allocates assets across different bond market sectors and maturities. For this chart, FBNDX was selected as the "Low Risk Basis".  This selection establishes the ratio of risk to return.

RR= Formula:
Return to risk ratio = (VFINX return - FBNDX Return)/ (VFINX SD - FBNDX SD)
               35.40 = (250.38-123.64)/(4.85-1.25)

RR     = 35.40 X (FSELX SD - FBNDX SD) + FBNDX Return
459.59 = 35.40 x (10.74-1.25) + 123.64
  Rounded SD calculations cause the slight difference from the chart RR=459.78

Given the VFINX/FBNDX context, the white line in the 2 Chart in the lower half of the screen shows the expected return of FSELX . Since the red line, FSELX, is more volatile than VFINX, it should have more return, and indeed it does. The long term gain of the red line bumps along the white line. 

VWUSX, an actively managed fund, has a higher SD= than VFINX, yet lower returns. This fund has poor risk-adjusted return shown by its falling below the white line.

If the red line has an SD that higher is than Standard Risk issue's SD or lower than the Low Risk issue's SD, then the white line cannot be computed and an error message appears. The white line will be displayed as a flat line.

Judging Dissimilar Funds

1) Load the WisdomTree ( WISTRETF ) family of ETFs.
2) Right click the ColorBar and checkmark "relevant index"
3) Step through the funds placing each successively into the red ColorBar cell.

What you will see is that a highly-correlated  index is loaded into the green line as you move from fund to fund.

If you use the J or 2 chart and display the white line (expected return = risk-adjusted return), then set the low-risk basis  to VUSTX and the Standard Basis to "Relevant index". The white line and WT fund will be displayed in the J or 2 Chart showing whether the WT fund succeeded or failed to beat expectations . . . WT funds currently are only modestly successful.

For a diversification analysis,
1) simulate your portfolio using averaging and then make that AVG the "low-risk basis"
2) Rank the WT family showing the UPI value for a recent period.

What you will see is that the funds with UPI values above 0 will help the risk-adjusted return of your portfolio. Negative values will hurt your portfolio.

Mutual Fund Risk and Return

The chart shows a scatter diagram of risk (Standard Deviation, X-axis) and return (Y-axis). Key benchmarks are highlighted. The points are for the Fidelity funds that existed for the period 9/1/88 - 5/1/98.

The risk/return of the S&P 500 (actually we used the SD and return of VFINX) falls in the middle of the spectrum. A short-term bond fund like FSHBX falls at the conservative end. A technology sector fund like FSELX falls at the aggressive end.

We drew a  red line using linear regression through the points. Funds above the line would be considered to have "good" risk-adjusted return. Funds below the line have "bad" risk-adjusted return.

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Note that points fall along a line drawn between the risk and return of FSHBX (a short-term bond funds) and the SP& 500 (Actually VFINX). FastTrack's J and 2 Chart white lines are drawn based, by default, on these two points. However, for international funds, sector funds, and other funds that do not correlate highly with the S&P 500, the white line would be inappropriate unless you change the issues that define the end points of the line. See parameter setting.

FSHBX defines the "Low Risk Basis" for many of FastTrack's calculations while VFINX define the "Standard Risk Basis" for calculations. 

Stock Risk and Return

The chart shows a scatter diagram of risk (Standard Deviation) on the X-axis and return (Y-axis). Key benchmarks are highlighted. The points are for the FastTrack stocks family ALL-NYSE  that existed for the period 9/1/88-5/1/98.

The diagram has more points, and the SD and returns span a greater range. You don't see the extreme ranges in funds because funds  average the performance of many stocks.

The red Mutual Funds risk/return regression line illustrates the risk-adjusted appeal of mutual funds. Funds are less volatile, yet offer good returns for the considering risk.

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It is MUCH harder to pick a good risk/return performer in stocks than in mutual funds. Mutual fund's appeal to the typical investor because the chances of getting burned are much less. However, it you can pick a few hot stocks, then the potential for return is much higher with stocks.

In this case, defining "Low Risk Basis" using VFINX and "Standard Risk Basis" as FSELX is not appropriate. Indeed, there is really isn't any appropriate basis for assessing risk vs. return for the all NYSE stocks. Note that many NYSE stocks are relatively low risk, low return preferred and convertible stocks which need a different basis for risk and return than regular common stocks.

S&P 500 Stocks, as subset of all stocks.

For the decade of the 1990's, the large companies of the S&P 500 haven't been as volatile as the broader family, NYSE stocks (chart above). Now the risk/return line defined by VFINX and FSELX is more appropriate, but still a bit high.

While it is unlikely that the S&P 500 stocks will continue this advantage, it is likely that you will do better owning with issues that have a FastTrack Standard Deviation under 10% . . .  remember that return prediction at  risk extremes of is impossible.

Beyond an SD=10.0%, DO NOT BUY and HOLD. Volatile stocks should be considered speculative investments that must be actively managed. Take profits and cut losses regularly.

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