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Properly assessing risks and returns on the investment tight wire

March 7, 2014 by Editor, InvestingForMe

The terms risks and returns are two of the most commonly used words you hear in any discussion about investing. For most of us, when we talk about our investment returns we simply mean how much money our savings made for us – or lost for us! And we like to quantify our returns by quoting a single number, where we say something like – Yes! I just made 10% on that investment! Or, as can also be the possibility – D’oh! I just lost 15% on that dumb investment! In any case, we like to think that a simple, single number says it all. But does it really?

 

And what about that other word – risk? That’s the other investment term we should all get to know better. We should also all think about an investment’s rate of return in relation to the risks that the investment takes on in order to become better investors.

Risks and returns: two sides of the same coin

In one of our previous articles we pointed out how two similar mutual funds (RBC Canadian Equity and TD Canadian Equity), with the same risk rating – Medium risk – experienced dramatically different investment returns in the 2008-2009 stock market decline. Despite the same risk ratings, one lost 23%, while the other lost double that amount. Clearly the risks associated with one fund were greater than the other.

But let’s face it. Most of us are lazy! We like things quick and simple and that’s why we like to reduce our investment returns to a simple, single number. But as with most things in life, investment returns are no simple matter.

To get a true sense of an investment’s real rate of return you need to put them in their proper context. And how do you do that? Well, first you have to try and assess how much risk you had to take to make that so-called 10% return or that 15% loss. And how do you assess the investment risk?

Well, for most people, the term risk simply means the chance they’ll lose money. But it can actually have multiple meanings to each of us. So let’s get some help defining what risk really means.

For example, when you read an investment’s risk described as medium, do you understand what that really means? Or do you simply think to yourself, Ok, well, I’m ok with medium-risk, I just don’t want any high-risk investments! If you’re like most of us, you simply assume that the investment professionals have done their homework and share the exact same definition of risk as you do and thus you trustingly accept their simple, one-word description of the investment’s risk. But as we discussed in our last article, a mutual fund’s risk rating is a creation of the fund’s very own investment managers, and how unbiased is that?

Risk-adjusted returns: get to know this term

Investors and investment professionals have long understood that an investment’s rate of return is directly linked to the amount of risk the investment presents. High-risk investments offer higher potential returns, and conversely, low-risk investments offer lower returns. And with this in mind the concept of an investment’s risk-adjusted rate of return was born.

By definition, an investment’s risk-adjusted return is a more useful measure of an investment’s rate of return because it attempts to measure the amount of risk that is taken to generate an investment’s return. It’s of great importance because it enables the investors to make an apples-to-apples comparison between returns for different investments.

Investment professionals use a variety of methods to assess an investment’s risk-adjusted return, but the 5 most widely accepted risk measures include the following, ranging from the complicated to the simple:

  • Alpha
  • Beta
  • R-square
  • Sharpe Ratio
  • Standard deviation

Sounds Greek, doesn’t it. Well, for most of us average investors, who actually has the interest or time to learn and apply any of these complicated measures? (Not me and I like investing!) So, next time, we’ll delve into the use of an investment’s standard deviation as this is the least complicated type of risk measurement that you and I are likely to use as a measure of risk-adjusted returns.

 

(Published by Troy Media)

 

 

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