Why do we invest? To make money, of course. But have we ever considered if the return we earn is commensurate with the investment risks we’ve taken? Put another way: It can be misleading to just look at headline figures when evaluating investment returns.
For instance, Bitcoin had a wild run in 2017 and its return for that year surged to nearly 1,900%. But once you adjust for risk – the chance of losing some or all of an investment – Bitcoin’s risk-adjusted return plummeted to a meagre 3.1%. Comparatively, the S&P 500 produced risk-adjusted return of 11% during the same period.
A Like-For-Like Comparison
Whether or not an investment is worth buying clearly depends on how much risk was involved in generating those returns. This sums up risk-adjusted returns, a concept which allows investors to directly compare investments by measuring the risk taken to produce their respective returns. If two investments have the same return over the same time period, the one with the lower risk has a better risk-adjusted return.
There are many ways to calculate risk-adjusted return. Sharpe ratio, Treynor ratio, Alpha, are some conventional examples; Sharpe ratio is most commonly used. The higher the Sharpe ratio, the better the risk-adjusted return.
But the Sharpe ratio is not a risk measure per se – it actually accounts for volatility, not risk because it considers how much an investment’s return fluctuates from day to day.
Don’t Confuse Risk And Volatility
Volatility is not the same as risk. Volatility measures the price fluctuations of a given investment over time, but risk is the possibility of a permanent loss of capital from said investment. Simply put, for an investor with a long investment horizon of say 10 years, it should not worry him that a particular investment is volatile. What should matter instead is the risk that an investor loses more than what is acceptable and therefore turns a temporary drawdown into a permanent loss by selling the assets.
But if he could know with a fairly high degree of certainty that for a particular time period, his investment will not lose more than X percent of its value in a given year, he would be more confident staying invested.
That’s exactly what Median Tail Loss (MTL) is. MTL is the downside risk measure Syfe uses to optimise risk-adjusted returns for all our portfolios. Investors are fundamentally loss-averse, and it is difficult to interpret what their possible investment loss could be just by knowing the volatility of an investment. MTL thus captures the loss potential or downside risk of a portfolio rather than just its up and down price variations.
What Median Tail Loss Means For Your Portfolio
At Syfe, we assess each investor’s risk appetite through a custom-built risk questionnaire and determine the corresponding MTL level that reflects your risk profile. We offer 11 risk categories ranging from 5 to 25. If you select a portfolio that that has a risk category of 17, what it means is that in 39 out of 40 years, your portfolio will not lose more than 17% in a given year. This is also why we use numerical risk categories instead of vague terms such as “balanced” or “aggressive” – investors know right from the start the level of risk they are taking on.
Syfe then constructs an Exchange-trade Fund (ETF) based portfolio that generates the best possible risk-adjusted return without exceeding your MTL level. This is done by optimising your portfolio’s asset allocation through our Automated Risk-managed Investments (ARI) technology.
Managing downside risk is the most important thing you can do for your portfolio because successful wealth creation stems from avoiding large losses. A 50% drop in your portfolio value requires a 100% gain just to get back to your original investment value. Such risk management is the cornerstone of Syfe’s investment process.
Many investors focus solely on returns when investing. But the amount of risk being assumed is as important – if not more so – than absolute returns. A good understanding of risk-adjusted returns will help you better assess the risk-reward parameters of your investment not just so that your investment risk-taking pays off, but also that you protect yourself against catastrophic losses from which there is no recovery.
This article was first published on DollarsAndSense as a guest post.