Uncompensated Risk In Investing

With the market gyrating like it's 2008 again, now seems like a good time to re-visit the unbreakable relationship of risk and reward.

While market returns can be defined in many ways, most media outlets and investment shops have come to use the S&P 500 as their benchmark for return. Unfortunately, comparing the return of the 500 largest U.S. stocks against a diversified portfolio is a very poor, even unacceptable measurement of performance. After all, most portfolios are comprised of both U.S. and foreign stocks, plus corporate and government bonds, real estate or other commodities, and cash equivalents.

When discussing investment returns, you’ll typically hear me refer to “risk-adjusted return” as a measure of how well a fund or portfolio did over a specific time period. Simply put, if two different funds/portfolios had a 10% return, the less risky one – perhaps one that owns more bonds than stocks – would have a much better risk-adjusted return

So to fairly and accurately measure a diversified portfolio, it must be adjusted for style and risk. For example, a portfolio that has been established for an investor may have a target allocation of 60% stocks and 40% bonds. In that case, the stocks and bonds should be broken down by type, (e.g. U.S. or foreign, small or large, etc.) and the returns for each then compared to their applicable benchmark. In this light, no one would reasonably compare such a 60/40 portfolio’s returns with the S&P 500, much less draw rational conclusions from it.

One method to adjust for risk is through a fund’s standard deviation, which measures its volatility. A stock fund, which is more likely to have returns that yo-yo, will have a high standard deviation. In contrast, the standard deviation of a fixed income or bond fund will be lower, or more likely to be in line with its expected historical returns in any given period of time.

Generally speaking, the returns of more stock-based models come with higher standard deviations, and therefore, higher risk. In the 12-15 months ending in April 2010, investors were compensated for this risk through higher returns. As you might guess, however, risk was not so well compensated throughout the past decade (or even the past month), when much safer fixed income investments performed as well as – or even better than – stocks.

Understanding the basics of risk-adjusted return will make you a more successful investor. It follows, then, that successful investors - and successful people - avoid uncompensated risk.