To assess investment performance accurately, you need to understand the risk undertaken to achieve it—evaluating risk-adjusted returns.

Dictionary.com defines risk as “the exposure to the chance of injury or loss; a hazard or dangerous chance.” 

American Heritage Dictionary says, “The possibility of suffering harm or loss; danger.” 

These are just two of the many entries, and these were just for the noun. Risk in the world of investments and finance is more succinct. Risk is the uncertainty of outcome. However, risk can be quantified whereas uncertainty cannot. Many use risk as a quantitative measure and uncertainty for measuring the nonquantitative type. This article will attempt to give a general overview of risk and identify a few of the problems associated with trying to measure it. Moreover, it will do so without any equations.

The importance of understanding risk-adjusted performance

I frequently hear from investors who are concerned about performance. They want to know the performance over the last month, the last quarter, the last year, the last five years, and so on. Rarely can I remember one of them also asking about the risk associated with a money management style.

Knowledge of performance without understanding the risk required to get that performance is worthless in most investment scenarios. Investors are generally aware of market risk—the risk you incur with exposure to securities whose prices move based upon movement of the forces of the overall market. Unfortunately, these investors were educated in a system that was essentially void of lessons on our credit or capital markets. They have been led to believe that market risk is just a “fact of life” when it comes to investing. I strongly believe differently. Performance without assessing the associated risk is not performance at all, but hope. Hope has its place in life, but not in investing.

Risk is measured in many different ways. You can open any mutual fund prospectus and read page after page of required documentation on numerous types of risk, such as interest-rate risk, credit/default risk, call risk, management risk, liquidity risk, and sovereign risk—just to mention a few. Grab a prospectus sometime—you will be surprised!

Awareness of these individual concerns is not nearly as important as the knowledge and understanding of accepting (requiring) performance on a risk-adjusted basis. These types of risk measures are attempts to quantify risk in such a way as to also know the bounds or extremes one may encounter. In a nutshell, risk measures are attempting to quantify uncertainty.

Investments that carry more risk usually (but not always) offer higher returns, or I should say expected returns. That makes sense, doesn’t it? If you take more risk, you expect to be compensated for it. Therefore, the assessment of risk is an important element of successful investing. Risk measures are based on historical performance. From this, we make our best estimates as to what the risk will be in the future. It is the best measure of future risk and needs to be updated frequently knowing full well that the future is not predictable.

Peter Bernstein, author of “Capital Ideas” and many other good books on finance, was asked, “What are investors’ most common mistakes?” His answer was simple and straightforward: “Extrapolation. Leaving fund managers in a down year to go with whoever’s hot.” He went on to offer another tidbit of sound advice when asked how an investor could reduce risk, “The riskiest moment is when you are right. That’s when you are in the most trouble, because you tend to overstay the good decisions.” My short list of great books includes two by Peter Bernstein: “Against the Gods” and “Capital Ideas.” Both are excellent reads and strongly recommended.

Diversification is not enough to mitigate systematic portfolio risk

The world of finance is fraught with theories on how to control risk in one’s portfolio. These theories, such as the capital asset pricing model, efficient market hypothesis, random walk, the options pricing model, and so on, are a sound basis for all financial analysis. Personally, I think they are a little heavy in their assumptions. One thing I really find fault with is their almost total belief that market risk can only be dealt with by diversification. Again, I do not believe this is the best way to handle market risk. I believe that when market risk reaches certain levels, one should take defensive action to prevent loss.

And finally, remember that the “world of modern finance” is entrenched in the belief that risk is measured by the variation of returns about their mean, or standard deviation. This is total nonsense. In order to use standard deviation, you have to completely accept that prices are random and normally distributed. They are not! That is, unless you work in the confines of the sterile laboratory of modern finance, their ivory tower so to speak.

I will close with something I keep saying over and over: The beauty of the technical approach to investing is that you are dealing with systematic risk. That is the risk of bear markets and drawdown. Those “other” folks only deal with non-systematic risk, also known as diversifiable risk. Think about it, how often do you read publications from wire houses (i.e., large brokerage firms) that constantly talk about diversification and rebalancing? But keep in mind that most, if not all, of their publications are for marketing purposes. It is hard to see that because they write so convincingly and “logically;” yet the publication is just there to make you feel the firms have your best interests at heart. If those “other” investors would ever wake up, they would sleep better.

Editor’s note: This article, written by Greg Morris, was published at StockCharts.com on Sept. 26, 2022. Many thanks to the author and StockCharts.com for permission to republish the article. Please see frequent commentaries by Mr. Morris on the blog Dancing with the Trend.

The opinions expressed in this article are those of the author and the sources cited and do not necessarily represent the views of Proactive Advisor Magazine. This material is presented for educational purposes only.