Why Do Risk-Adjusted Returns Matter?

A reader writes in, asking:

“Why do academics always talk about risk adjusted returns? I get that risk matters and you shouldn’t have a riskier portfolio than you can manage. But if I compare two strategies over a period, I’m better off at the end if I used the strategy with the higher return, not the one with the higher risk adjusted return. So why is risk adjusted return relevant?”

The usefulness of the risk-adjusted return concept is that we can use it to evaluate a proposed strategy to determine whether it has historically been a better way to increase returns (or reduce risk) than simply adjusting any of several other well known variables (e.g., stock vs. bond allocation, duration of bond holdings, credit quality of bond holdings, etc.).

For example, imagine that you currently have a 50% stock, 50% bond portfolio that uses simple “total market” index funds for both the stock and bond portions. But then you meet with a financial advisor who suggests that you would be better off if you got rid of your total market stock funds and switched to a portfolio of individual stocks, picked according to a specific set of criteria. And this advisor shows you historical data demonstrating that his hand-picked stock portfolio has had higher returns over the last several years than your total market stock funds.

Obviously, one problem here is the critically dubious implication that the past is a good predictor of the future. But let’s set that aside for the moment to focus on another problem: A portfolio comprised of a handful of individual stocks will generally have far more risk than a broadly diversified total market stock portfolio.

In other words, the advisor isn’t making an apples-to-apples comparison, and he has not demonstrated that his strategy is actually an improvement over a total market strategy. What needs to be demonstrated is whether the 50% bond, 50% hand-picked-stock portfolio the advisor is proposing has had greater returns than an index fund portfolio with the same level of risk.

For example, you might find that the advisor’s 50/50 strategy with handpicked stocks has historically had a risk profile comparable to a 70/30 stock/bond portfolio using total market funds but that its historical annualized return is closer to that of a 60/40 portfolio using total market funds. If that’s the case, then the advisor has clearly not added any value. All he has done is bump up the risk and return in an inefficient way. A 70/30 total market portfolio would have had higher returns with the same level of risk as what the advisor is proposing, and a 60/40 total market portfolio would have had the same level of returns, with less risk than what the advisor is proposing.