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Basis for Risk Return

Updated 01/31/14

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The concept is simple: For every unit of additional risk you get a unit of additional return.This is true in the broadest sense but note that the rule does not hold at the extremes:

  • Extreme High end: What are the chances that your $1 lottery ticket will win the $150 million Power Ball Jackpot? Risk essentially becomes infinitely large thus risk-adjusted return cannot be calculated. PRECIOUS family mutual funds (gold funds.) and many stocks have extreme risk levels.

  • Extreme Low end: With a passbook savings account, risk essentially goes away, but there is still return. Risk essentially becomes infinitely small thus a meaning full risk-adjusted return cannot be calculated. Many mutual funds but only a few stocks come in at the low end of risk.

  • In the Middle: FastTrack can predict return based on volatility as measured by Standard Deviation (SD=). This concept is discussed with several examples in the topic Risk-Adjusted Return. This section discusses controlling parameters which govern how the predicted return is calculated. This middle ground is occupied by most stocks and most equity mutual funds.

In the Parameters Dialog Box

Click  for a more complete discussion of setting parameters. The following discussion concerns the settings of the "Basis for Risk Return" box within the Parameter Dialog.

There are two selection boxes. Click on the down arrows to see the choices. Pick two  issues, indices, or averages to define the Basis for Risk Return, the Standard basis and the Low basis (highlighted to the left by a red bracket { . These choices define the risk return ratio for a line drawn on the J and 2 Charts' white line calculation. You may key in your own symbol for the Standard or Low basis, or pick the from the dropdown  list for each.

VFINX (the classic Vanguard S&P-500 fund) occupies the broad middle of equity averages. FSHBX is a typical short-term bond fund. Thus, these two are good choices as one of the parameters. 

VFINX/FSHBX might be the Standard/Low parameter when judging very volatile stocks or volatile funds like HITECH mutual funds.

 SOX-X is a volatile technology index)VFINX would be a good typical choice for the Standard parameter when judging low volatility INCOMEQ mutual funds.

FSHBX is a good choice for the Low basis 

Error Message

If the red line has an SD that is lower than the Low issue's SD, then the white line  cannot be computed. To fix the problem choose a less volatile Low issue or a more volatile Standard issue as the Basis for Risk return.

Note: By default the white line of the J and 2 Charts that displays the expected return is NOT visible. Check the Rr= box to make it visible.

Applying Risk/Return to Investing

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 mutual 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. Mutual funds above the line would be considered to have "good" risk-adjusted return. Mutual 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 mutual funds, sector funds, and other mutual 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.

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 range in mutual 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. Mutual 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.

S&P 500 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, ALL-NYSE stocks (chart above).

While it is unlikely that the S&P 500 stocks will continue this advantage, it is likely that you will do better 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. These are speculative issues that must be actively managed. Take profits and cut losses.

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