Risky Business
Risk-adjusted returns cost money!

by Ann Coleman (TMF AnnC)

Reston, VA (May 17, 1999) -- One criticism that has been leveled at the Foolish Four (and many other strategies) is that it when you adjust its higher-than-average returns for "risk" then the advantage of the strategy disappears.

This is a persistent criticism that I have never quite bought into, try as I might. (And I did really try.) Here's how it works: Strategy X beats the market by 6% a year, but the strategy has a higher standard deviation (meaning the returns show more variety over time, i.e., more years with higher highs and lower lows than the market). If you adjust the strategy for this additional "risk," usually by putting some of the money into bonds instead of stocks, so that the standard deviation is the same as the market, then you lose some or all of the excess return. Therefore, the strategy is no better than the market.


First, let's talk about what risk actually is. One definition is the "volatility" of the returns. This is measured by things like "beta" (which we discuss in our FAQ), standard deviation, and the Sharpe Ratio. This definition of risk is a wonderful one if you want something quantifiable. I'll spare you the math, but you can calculate it several ways by comparing how much each year's return varies from the average return. Stocks with low volatility tend to have returns that are closer to the average return, whereas high-volatility stocks jump around more from year to year.

There are various ways of making such comparisons. Standard deviation looks at how widely spread out the returns are from the midpoint. Beta compares the variability of a single stock (or industry, or whatever) with the market as a whole. There are a number of formulas that will adjust returns to equalize the risk, and doing so is a good exercise if you like that sort of thing.

But don't kid yourself. You can't spend a "risk-adjusted" return. Giving up real returns for a better risk-adjusted return means giving up cash.

And for what? That's where I just fail to make the leap. The risk of volatility is that your money might not be available when you want it. A highly volatile portfolio might be up 40% one year and down 40% the next. Well, if you intended to use that portfolio for a down payment on your house, you could be up the proverbial creek.

That's why we preach, preach, preach that you should only put money that you won't need for the next 5 years (at least) into stocks. Keep the rest in a CD, a money market account, or hide it in your mattress, but don't put it in stocks. Once you do that, the volatility issue goes away.

The only risk worth worrying about at that point is economic risk. What is the risk that this company is going to go belly up? Are you engaging in risky investing practices that could result in absolute losses where no matter how long you wait, there is no recovery? A stock that drops 70% one year but is up 500% over the next three years may be bad for your Maalox bill but great for your retirement plans. Not everyone should be invested in such stocks -- you have to know your risk tolerance and really know what you are doing -- but for those who can stand the ride, the rewards are the kind we Fools like. Real spendable cash.

Unfortunately, real economic risk is not nearly as easily quantified as volatility. It's a judgment call, which makes it very difficult to plug into an equation. So volatility has been the definition of risk, by default it seems, for those who want to do risk analysis.

When it comes to a strategy like the Foolish Four, where the risk of absolute, multi-year loss in all four stocks is extremely low (we aren't dealing with penny stocks here!), the idea of risk-adjusted returns is just plain silly. Yes, some individual stocks will show losses, and occasionally the entire portfolio will have a bad year, but only once in the past 38 years has the strategy lost money two years in a row -- and over the next decade, the Foolish Four absolutely creamed the market, beating it by an average of 12 points per year. That's upside volatility.

Anyone investing in a Dow strategy should understand that the returns may be more volatile than the market (although the standard deviation for the super-safe High Yield 10 strategy is actually lower than the market). They should also understand that that volatility can work in their favor over the long run.

Fool on and prosper!

Call Your Boss a Fool.

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Today's Stock Lists | 1999 Dow Returns

05/14/99 Close
Stock  Change   Last
CAT  +   1/8   61.13
JPM  -4        136.94
MMM  -1  1/16  89.25
IP   -   1/8   53.00
                Day   Month    Year   History
        FOOL-4   -0.97%  -1.18%  27.42%  29.32%
        DJIA     -0.55%   0.60%  18.60%  18.13%
        S&P 500  +0.13%   0.32%   9.29%   9.55%
        NASDAQ   +1.34%   0.75%  16.84%  18.44%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     61.13    41.89%
 12/24/98    9 JP Morgan    105.51    136.94    29.79%
 12/24/98   22 Int'l Paper   43.55     53.00    21.70%
 12/24/98   14 3M            73.57     89.25    21.31%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1467.00   $433.00
 12/24/98    9 JP Morgan    949.62   1232.44   $282.82
 12/24/98   14 3M          1030.00   1249.50   $219.50
 12/24/98   22 Int'l Paper  958.12   1166.00   $207.88

              Dividends Received      $29.45
                             Cash     $28.26
                            TOTAL   $5172.65