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How the Market Works

Delusions of Grandeur: Risk Adjusted Returns & How the Market Works

Posted by kdadmin on August 8th, 2016.

Delusions of Grandeur:  Risk Adjusted Returns & How the Market Works

It seems like every day the market hits new highs. And each day it seems like the press lauds it as the Biggest Deal Ever.

Except that it isn’t …

Delusions of Grandeur

Look at the chart above. What do you notice? How about that the blue line (SPY – S&P 500) is only a smidgen higher than the orange line (AGG – Corporate Bonds) over the last year, even at it’s supposed Biggest Deal Ever recent market high? Now notice how a major foreign market (VGK – European Market) has gone down the drain with a 14% loss?

Think about this for a moment.

If SPY has only posted a 6.11% gain, but has the potential to lose nearly 46% in a single year (like during the Great Recession), are you really going to want to take that kind of risk for such a tiny reward? I’m not. Look instead at AGG. It posted a 5.63% return, but holds only about 1/9th the risk of SPY, for a potential loss of 6%, wouldn’t this be a better risk/reward trade off?

Risk Adjusted Returns

One of the best way to compare different investments is on a simple risk adjusted return basis. This answers the basic question of most investors: “How much return (gain) can I expect for the risk (loss) that I’m taking?” In other words, “How efficient is each investment at producing return for my risk?” The goal is 100%. Once you boil various investments down to this level, it’s a lot easier to compare them.

Now, for you financial advisors who read my blog, we all know that trailing standard deviation is the gold standard for risk evaluation, except maybe in compressed volatility times like these. However, I’m going to simplify the risk adjusted return calculation in a way that is more approachable for the investing public.

For the rest of you, here’s how we’re going to do it: current one year return divided by the worst one year loss in the last ten years. For SPY and VGK that is March 4, 2008 – March 4, 2009, with losses of 46% and 57% respectively. For AGG, that is September 6, 2012 to September 6, 2013, with a loss of 6%. This will give us an idea of just how bad things could be for each investment option should the market turn against it.

Let’s do the math:

  1. SPY: 6.11% / 46% = 13% efficient
  2. AGG: 5.63% / 6% = 93% efficient
  3. VGK: -14% / 57% = -25% efficient

What does this tell us? It tells us that AGG is the most efficient investment per unit of risk of loss. AGG produced 5.63% return with a risk of 6% loss. Compare that with a mere 13% for SPY and -25% for VGK.

Say what you want about whether or not the stock market (SPY) is going to go to the moon, but point for point, the stock market (SPY) would have to produce a 43% return in order to be as efficient as the corporate bond market (AGG) has been over the last year. Good. Luck. And VGK would have to hit a laughable 53%.

How the Market Works: Right Now

Obviously, the first argument against my formula is that it doesn’t take into the years when the stock market (SPY) went up by 10-15% per year. That’s true. But that’s not happening NOW. And right now, we’re concerned with right now. We’re obviously in a market transition period, and we want to know how hurt we can get if/when the market turns south.

Look, the bottom line is that we’re at record stock market highs, corporate earnings are dropping, interest rates are (slowly) rising, QE is being unwound, manufacturing numbers are lousy, Europe is a disaster with Brexit, and eventually, Frexit, Nethexit, Germexit … It’s much more likely over the next several years, that we’ll be looking at a decline in the stock market rather than a massive increase.

Most investors want to know if the risk inherent in the stock market right now is worth the meager potential gains. Personally, I don’t think so. I’d prefer a much more efficient, and safer, portfolio of corporate bonds (AGG). And, I imagine, so would my clients. Have a look at how we did with this strategy over the last year.

The Next Steps?

Learn about bonds. Start here.

Then, contact me to review your portfolio.

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