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Risk Adjusted Returns: What’s the Point?

A reader writes in, asking:

“I don’t understand the point of ‘risk adjusted’ returns. All I’m concerned with is actual returns. If a change to my portfolio ‘improves’ my risk adjusted return but does not improve the actual return, it doesn’t seem like I actually benefit from it.”

I’m sure you would agree that any change to your portfolio that results in an increase to expected return without an increase in risk is an obvious “win.”

Similarly, any change to your portfolio that reduces risk without decreasing expected return is also a “win.” What may not be obvious is that, in such a case, you have the option of happily accepting that lower level of risk, or, if you prefer, you could do something else that brings your risk level back up to what it was before (e.g., shift your stock allocation slightly upward), but now with a higher level of expected return.

In other words, those two things — an increase in expected return without an increase in risk, or a decrease in risk without a decrease in expected return — are somewhat interchangeable. A decrease in risk can easily be exchanged for an increase in expected return.

More broadly, the concept of risk-adjusted return is asking: once we have determined approximately how much risk is acceptable for this portfolio, how can we get the highest expected return for that level of risk?

Everybody Has a Risk Limit

Over the years I have come across several young, risk tolerant investors who have told me that they do not care about risk at all. All they are concerned with is return (or expected return).

That’s nonsense.

Every investor has a limit to the risk they can accept.

Even if your portfolio is 100% stocks right now, you are still forgoing higher-risk, higher-expected return options. For instance, instead of just 100% stocks, why not 100% small-cap value stocks? And why stop at 100%? You could borrow money to invest (i.e., invest on margin). You could short a bond ETF (e.g., have an effective allocation of 110% stocks, -10% bonds). If you haven’t done such things and choose not to do such things, you too have a limit to the risk you will accept.

Sometimes the limit is a financial limit (you cannot afford to take on more risk), and sometimes the limit is a psychological limit (you cannot tolerate more risk). But you definitely have a limit.

Caveats

While the concept of risk-adjusted return is useful for understanding portfolio construction discussions, applying it in real life comes with important caveats.

Firstly, there are many ways to measure risk. Standard deviation of returns is the most popular measure historically. But looking only at the standard deviation of a distribution gives you an incomplete picture. For instance, as Larry Swedroe often mentions, it is helpful to also consider skewness (i.e., how asymmetrical is the distribution of returns) and kurtosis (i.e., how far is the distribution from a normal distribution — how fat are the tails).

And for a retirement stage portfolio (as opposed to an accumulation stage portfolio), we’re concerned with an entirely different set of risk metrics (e.g., probability of portfolio depletion, size of portfolio shortfall, etc.).

Secondly, portfolio changes that clearly achieve either of the goals that we’re discussing here (that is, a reduction in risk without a reduction in expected return or an increase in expected return without an increase in risk) are rare. And you want to have a high degree of skepticism when somebody suggests that they have a way for you to do so, other than simply “diversify” and “reduce costs.”

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