Investment – Measuring Risk and Return

My observation is that many people with investment portfolios receive less than market returns and take higher than market risk. This means they have inefficient portfolios.

(1) Most people do not construct investment portfolios on the basis of an intelligent framework (or model) for making investment decisions. Most investment portfolios are constructed on the basis of intuitive predictions and the last best investment.

(2) Most people measure their return on capital but don’t understand that this is meaningless information unless it is compared with a market benchmark (are you receiving more or less than the market rate of return?). Also, most people don’t measure how much risk they are taking compared to market risk (managing risk is the key to investment success).

Click here to read about basic investment principles that should be a part of your framework for making investment decisions.

• Low risk investments (cash) deliver a low return and high risk investments (shares) deliver high returns

• The return you receive for making an investment is the reward for the amount of risk that you take

· If someone advises you to invest in the stockmarket, then as a minimum you are entitled to the market rate of return

· Simply invest in an indexed fund and you will receive the market rate of return

· Very few people do this and instead they choose to invest actively to receive a higher return

· Most people fail to achieve the market rate of return and few are able to consistently achieve a higher than market return

It is important that you understand where your investment return is generated and where you are taking risk. The only way that you can know this is to measure it in your investment portfolio. If you don’t measure risk then you can’t manage it.

We can measure your risk and return and show you where you are taking too much risk.

We provide a service where we measure and analyse the different elements of your portfolio that affect risk and return (we call this a Benchmarking Analysis). We then compare the risk and return of your portfolio against the market risk and return and other benchmarks. This places you in a position where you can understand how efficient your portfolio has been in capturing the return of the asset classes in your portfolio and you will see whether you are taking any risk that is not rewarded with an appropriate return.

Our process is to collect data on the month end prices of each of your investments and we can then calculate the average annual return your portfolio would have delivered if you rebalanced to your present asset allocation annually (which you should have done). We will also calculate the return of each individual investment and the amount of risk you have taken in each investment, as well as the overall portfolio. We use standard deviation to calculate risk.[1]

We will construct a market portfolio made up of indices with the same asset allocation as your portfolio and perform the same measurements over the same time period.

The market portfolio gives us the market (or index) rate of return for a portfolio with your asset allocation. This is the minimum return that you should receive. The risk of the market portfolio gives you a benchmark to compare with the risk in your portfolio. You will then be able to observe how efficient your portfolio is, in terms of being rewarded for the risk that you take.

Click here if you would like us to prepare a Benchmarking Analysis of your portfolio.

We charge a fee for this service. The fee relates to the number of investments in your portfolio and therefore the amount of time we spend in analysis. We will advise you of the fee and ask your approval before we do any work.

This website has been designed by Adjunct Professor Wesley McMaster of RMIT University. Wes McMaster is also a Certified Financial Planner and an Authorised Representative of DDM Financial Planning Pty Ltd, AFSL no. 384727.

[1] Standard deviation is a measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance. It is a statistical measurement that sheds light on historical volatility. For example, a volatile stock will have a high standard deviation while the deviation of a stable blue chip stock will be lower. A large dispersion tells us how much the return on the investment is deviating from the expected normal returns. Assuming that an investment is capable of producing negative returns, then it is generally the case that volatility increases the risk of capital loss as the investment time frame shortens. Standard deviation is commonly used as a proxy for risk in finance. Risk is defined as uncertainty about future investment returns. Volatility is a measurement of that risk.