Understanding Risk-Adjusted Performance

Introduction

Are you an individual investor looking to assess the performance of your portfolio? While many investors focus only on investment returns, risk-adjusted performance measurements are increasingly becoming more important.

In this blog post, we'll explore how understanding risk-adjusted performance can provide a better indication of how successful an investment has been and help inform future investment decisions.

A "Risk-First" Approach

When evaluating investments it may come as a surprise, but the return is one of the last things I look at. What I am more interested in the "quality of the experience". An investment strategy that offers a high return but has huge swings up and down along the way will be eliminated from consideration. 

First, many investors will find the emotional toll of the price swings too great and bail on the first large loss and thus missing any future upside. 

Second, the mathematical laws of compound interest favor the consistency of returns. A strategy that experiences large losses must then overcome those losses before new wealth is created. When it comes to wealth building, long-term consistency will put you in the winner's circle. 

Understanding risk-adjusted performance is key to making informed decisions about investments. This measure of performance takes into account the risk that an investor takes when investing in a certain asset, giving them a more accurate picture of the potential return their investment could yield. Risk-adjusted performance measures allow investors to compare investments with different levels of volatility and accurately evaluate which one offers the best risk-reward ratio.

Measuring Risk

There are several metrics used to measure risk-adjusted performance, including the Sharpe ratio, the Sortino ratio, and the Calmar ratio.

Of the three, the Sharpe Ratio is one of the most popular. It is calculated by subtracting the risk-free rate from the return on investment and dividing it by its standard deviation. In simpler terms, it defines how many units of return are being provided per unit of risk. The higher the Sharpe Ratio, the better risk-adjusted performance an investment has. 

The Sharpe ratio indicates how well an equity investment performs in comparison to the rate of return on a risk-free investment, such as U.S. government treasury bonds or bills.

Another commonly used risk-adjusted measure is the Sortino Ratio, which takes into account only downside risk by subtracting the risk-free rate from the return on investment and dividing it by its downside deviation.

It is a modification of the Sharpe ratio but penalizes only those returns falling below a user-specified target or required rate of return, while the Sharpe ratio penalizes both upside and downside volatility equally

The Calmar ratio is defined as the average annual return of an investment divided by the maximum drawdown (peak-to-trough decline) of the investment over a specified period of time. The higher the Calmar ratio, the better the risk-adjusted performance of the investment.

As important as these measurements are, perhaps there is no better measure of risk than what is known as the Maximum Drawdown. 

Maximum drawdown (MDD) is a measure of the peak-to-trough decline of an investment or portfolio, typically measured as a percentage of the peak value. It is an indicator of the largest loss that an investment or portfolio has experienced, which allows investors to measure the risk of their investment strategy.

It starts with an initial high point and compares the subsequent low point (valley) to the initial high point. the difference between that low point and the initial high point represents the MDD. It is an important metric because it helps an investor to determine how much of a loss they can tolerate before they would have to liquidate the asset.

For example, if an investment starts at a value of $100 and its highest value is $150, and then falls to a value of $50, the drawdown would be 50% ((150-50)/150)

Maximum drawdown is often reported as an annualized value so that it can be used to compare investments or portfolios with different time horizons.

One of the difficulties associated with passive index investing is that it exposes investors to large and devastating drawdowns. 

For instance, the largest drawdown of the S&P 500 index during the 2008 financial crisis was around 56.8% which occurred between October 2007 and March 2009. The market fell by around 57% in just over a year due to a combination of factors, including the subprime mortgage crisis, the failure of several large financial institutions, and the resulting global credit crunch.

Another example of a large drawdown in the past 20 years was the dot-com bubble of the early 2000s, the S&P 500 index had a maximum drawdown of around 49.1%, which occurred between March 2000 and October 2002, this drawdown was primarily caused by the dot-com bubble bursting, as well as the terrorist attacks on September 11, 2001.

The reason I think MDD is the most important metric and is the first thing I look at is threefold.

1. Psychologically, it is very hard emotionally for investors to experience drawdowns much of 20%. There were a lot of investors who capitulated in March 2009 but never got to experience the rise to new all-time highs. 

2. Mathematically, the larger the loss, the even larger loss needs to recover. A 20% loss requires a 25% gain to get back to even. If an investor loses 50% then it will take 100% to get back to even. 

3. While an investor may eventually recover nominally from a market loss, and an investor will never get back the time spent recovering from a loss.  And in some instances, that can take decades. 

So the next time you are considering a new investment, skip over the returns and look at the risk metrics. At the end of the day, it is these considerations that will determine more than anything else, your likelihood of long-term success,  

Fortunately for investors, every Drawbridge strategy is built to minimize downside risk. In fact, the drawdown chart is predominately displayed, to make it easy for investors to see this all-important metric.