This is the third post in a continuing discussion regarding evaluating the performance of your investment portfolio. In my prior posts I explained why investors should focus on the total return of their entire portfolio, as compared to the yield generated by the portfolio or the returns generated by individual investments included in the portfolio. This time I would like to explain why portfolio risk is such an important consideration when evaluating portfolio performance.
Portfolio risk has two principal components: volatility and variability. Volatility refers to fluctuations (up or down) in the value of a portfolio. Variability measures the frequency of the change in value. A portfolio that has less variability and volatility is considered safer than a portfolio with frequent (variability) and large (volatility) changes in value.
There are numerous ways to calculate the amount of risk inherent in a portfolio (or the investment strategy used to manage a portfolio). One of the best known and highly regarded measures of portfolio risk is the Sharpe Ratio. Developed by Nobel Prize winning economist William Sharpe, the Sharpe ratio is intended to calculate a portfolio’s returns relative to the amount of risk that was assumed to generate those returns. The higher a portfolio’s Sharpe ratio, the better. The Sharpe ratio can be calculated as follows:
(Portfolio Return – Risk-Free Rate) / Standard Deviation
Another way to express portfolio risk is in terms of the portfolio’s potential for drawdowns. Maximum Drawdown (“MDD”) is a measurement of decline from a portfolio’s peak value to its lowest value over a specific time period. Drawdowns are usually expressed as a percentage, which can be calculated as follows.
(Lowest Portfolio Value – Peak Portfolio Value) / Lowest Portfolio Value
If two investment strategies have the same returns but different MDD’s the strategy that had the lower MDDs would be preferable.
The Importance of Risk When Evaluating Investment Performance
There are two primary reasons why risk is such an important consideration when evaluating a portfolio’s performance. The first is mathematical and the second is psychological.
From a mathematical perspective, drawdowns can have a very detrimental impact on portfolio performance due to the impact of compounding, which Albert Einstein referred to as “the most powerful concept in the universe”. For example, if a portfolio’s maximum drawdown is 50%, the portfolio will need to double in value to reach its previous high. The greater the loss, the greater the impact of this phenomenon. As you can see below, a 100% gain is needed to make up a 50% loss.
The impact of MDD on investment performance – a 100% gain is needed to recover from a 50% loss
From a psychological perspective, portfolio volatility often leads to poor investment decisions, due in large measure, to human nature’s tendency to over-emphasize recent experiences. Allow me to illustrate my point.
Mrs. Commentator has fun playing slot machines (for amusement purposes only). Being a highly educated and intelligent woman, Mrs. Commentator is fully aware each bet is a statistically independent event; that is prior outcomes have no effect on the next bet. Nonetheless, if a particular machine does not pay off after a handful of events, Mrs. Commentator begins looking for a different machine to play. Likewise, if her first few bets on a new machine pay off, Mrs. Commentator regards that slot machine as being “hot” and will be reluctant to try another.
The same tendency to over-weight recent experience is often observed in investing. Even seasoned investors are tempted to abandon intelligent, mathematically supported strategies that have performed poorly as of late, and to praise ill-conceived strategies that have recently done well. As a result, most investors will be hard-pressed to stick with more volatile (risky) portfolio strategies when those strategies experience the inevitable period of below market returns, even though sound empirical evidence suggests the strategy is well-suited to the investor’s financial goals.
Even the best investment strategies should be expected to under-perform in certain market conditions, and poorly conceived investment strategies can have periods of out-performance. Because investors are more likely to stick with investment strategies that limit the volatility and drawdowns, the degree of risk inherent in a strategy can have a major impact on its ability to help an investor achieve his or her financial goals. In short, successful investing is as much about minimizing regret as it is about maximizing returns.
Next time we will discuss the role taxes play when evaluating investment performance. I look forward to sharing my views with you on this very important topic.
 Standard deviation of portfolio returns is a statistical measure of the disbursement of the portfolio’s returns in relation to the portfolio’s average return. In other words, a small standard deviation means the portfolio’s returns do not vary (either positively or negatively) much from its average return. A large standard deviation means the portfolios returns frequently significantly deviate (both positively and negatively) from its average return.
Important Disclosures: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly from The Market Commentator℠, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in The Market Commentator℠ serves as the receipt of, or as a substitute for, personalized investment advice from The Milwaukee Company™.