Don’t Be Fooled By Returns Alone

22 September 2017  |  Adam French
Don’t Be Fooled By Returns Alone
When choosing an investment, analysing past returns alone will lead to some nasty surprises.
The risk/return ratio says much more about the quality of an investment and it’s a figure we regularly refer to at Scalable Capital. Here we explain why it is so important.

Have you ever owned a single stock? Or invested in a fund? When you think about how satisfied you were with that investment, which particular element do you consider first? Most investors jump straight to their return relative to markets. An investor would probably be frustrated if the FTSE 100 increased by 13% over the same period that their investment increased by only 8%.

It’s only natural that an investor wants to generate a decent return, so it’s understandable that investors immediately focus on that number. However, we believe that the focus should fall on the risk/return ratio instead which says a lot more about the quality of an investment than return alone. To illustrate, we compare two investments that started at the same point, developed differently over the year but ultimately yielded the same return.

Their Returns Are Identical but Their Journeys Very Different

The annual performance of Investment A and B

The annual performance of Investment A and B

Which investment would you prefer to have owned? Although the return is the same, I suspect the vast majority would have rather owned Investment B. Holding Investment A would have resulted in some sleepless nights; just one month into the holding period and almost 30% of capital has been lost. After a temporary recovery in late spring, the investor would have been hit by another 20% loss. Quite the roller-coaster. Had the investor lost his nerve and decided to sell Investment A during the downturn, he would have missed out on the later recovery and crystallised a heavy loss.

There is also a risk that an investor may suddenly need to liquidate their money earlier than expected. Redundancy, divorce, a new car – expensive and sometimes unexpected events that immediately require cash do happen and may mean an investor is forced to sell at a bad time. Holders of Investment A will not want to be forced to liquidate at the wrong time and realise a significant loss. Holders of Investment B will be more able to liquidate with confidence at whatever time they need.

Therefore, the key question is: how much less return would you be willing to accept in order to avoid fluctuations? If the past return on Investment A was a percentage point higher than that on Investment B, would you go for it? Possibly not. But at some point, the relationship starts to tip – offer enough return and investors will start to disregard the fluctuations. You’re on the right track if you are starting to consider how much risk you would be willing to take for the return achieved; return relative to the risk of loss is what matters.

Financial professionals know this. They have several calculations to measure risk/return – the main difference between them is the way in which risk is measured. Here we discuss the three most important calculations.

1. Sharpe ratio

The Sharpe ratio is the most common measure of risk/return and is the standard generally used across financial services. It is the average return achieved over the ‘risk-free rate’ per unit of volatility. The ratio uses volatility as the measure of risk. Volatility describes how much the return on an investment fluctuates over time and is measured using standard deviation.

The Sharpe Ratios of Major Indices in 2016*

The Sharpe Ratios of Major Indices in 2016*

*Incl. dividends. Time period: 31.12.2015 to 31.12.2016

The return on short-term UK government bonds is usually considered to be the risk-free rate – they carry almost no risk. The higher the Sharpe ratio, the better the risk/return ratio (otherwise known as the risk-adjusted return).

The Sharpe ratio = (r-rf) / σ

Where: r = portfolio return, rf = risk-free rate, σ = standard deviation of the returns

The ratio is so commonly used because the risk of an investment is often equated with volatility, but this is a very questionable assumption. Volatility assumes that the negative and positive changes in value are evenly distributed. However, in reality, violent crashes happen far more frequently than strong upward increases. Standard deviation does not account for this asymmetric distribution of returns, so results will be inaccurate when using Sharpe to analyse assets with non-normal distribution.

The Sortino Ratios of Major Indices in 2016*

The Sortino Ratios of Major Indices in 2016*

*Incl. dividends. Time period: 31.12.2015 to 31.12.2016

2. Sortino ratio

The Sortino ratio differs from the Sharpe ratio by taking only the negative standard deviations into account – it looks at downside returns only. However, this doesn’t solve the problematic assumption around the distribution of returns, so the Sortino ratio suffers from the same weakness as the Sharpe ratio. Like the Sharpe ratio, the higher the Sortino ratio the better.

Sortino ratio = (r-rf) / σd

Where: r = portfolio return, rf = risk-free interest rate, σd = downward standard deviation

The chart shows that while the Sortino ratios of the indices in 2016 are different to the Sharpe ratios, the order in which they fall remains the same.

The Return/Drawdown Ratios of Major Indices in 2016*

The Return/Drawdown Ratios of Major Indices in 2016*

*Incl. dividends. Time period: 31.12.2015 to 31.12.2016

3. Return/Drawdown Ratio

This calculation uses maximum drawdown as the risk measure instead of volatility. Maximum drawdown is the maximum loss that would have occurred had an investor entered and exited the market at the worst times. It indicates the loss under the most extreme circumstances. It is also very simple to understand. Maximum drawdown is an easy measure for everyone to follow, whereas volatility needs some statistical knowledge.

By contrast to volatility, this measure is free of dubious assumptions about distribution. For example, in 2016, the FTSE 100 recorded a maximum loss of just over 11%. You don’t have to be a financial professional to understand that figure.

The return/drawdown ratio is calculated using the following formula:

Return/drawdown ratio = r / MDD

Where: r = portfolio return, MDD = maximum drawdown

The effectiveness of the return/drawdown ratio as a measure of risk-adjusted return is best illustrated by the example referenced at the beginning of this article (Investments A and B). Here we use the different ratios to calculate the risk-adjusted return of those investments.

Risk-Adjusted Return of Investment A and B

Investment A clearly has a higher Sharpe ratio than Investment B, although almost every investor would consider Investment B to be the better option. By using the Sharpe ratio alone, the investor would have misjudged the two investments. The return/drawdown ratio gives a much clearer indication of the relative quality of the two investments and in this instance it shows that Investment B comes out on top.

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Adam French
CO-FOUNDER & DIRECTOR
Adam spent the last 8 years working in London in the financial services industry. As Executive Director of Commodities Trading at Goldman Sachs, he was responsible for the Commodities Structured Products franchise. Prior to this, he worked in Derivatives Trading where he was responsible for electronic trading for private clients in fixed income, currencies and commodities products. Adam studied Business Mathematics and Statistics at the London School of Economics.