Enough About Portfolio Return, Let’s Discuss Measuring and Understanding Portfolio Risk.

 

How will your portfolio survive in a down market?  Several economists are predicting a recession for the U.S. economy in 2008.  Some believe we are already suffering such pains.  Only during difficult market conditions do clients start asking ‘how much risk is my retirement portfolio taking and how do I measure such risk?’ 

 

Measuring risk is an under utilized investment tool.  Unfortunately, discussing risk is not as glamorous as discussing returns at the most recent cocktail party.   Fortunately for all of us, Nobel laureates Harry Markowitz, Milton Friedman, and William Sharpe worked together to create portfolio risk metrics commonly known as  Modern Portfolio Theory (MPT) and the Capital Asset Pricing Models (CAPM).  Below I discuss some of the more basic components of MPT and CAPM.  I outline beta, standard deviation, and alpha.  More importantly, I illustrate how three Nobel laureates provide us a way to measure portfolio risk. 

 

Measuring portfolio risk requires using a specific benchmark. This article uses the S&P 500 as the benchmark.  During this article, I will also mention a mutual fund our firm uses.  We use only one fund for simplicity, but as I do not suggest using only one fund to construct a balanced investment portfolio.  I will be hosting a web seminar in February discussing the below risk measurements in conjunction with an actual portfolio we manage.  Please email us at james.dinardo@nmfn.com if you wish for us to send you the information for the web seminar.  We will need your name, phone number, and email address to send you the web seminar information.  The seminar will be limited to 15 people.

 

Let’s start with my favorite of the risk measurements – BETA.  According to Morningstar, beta is a measure of a fund’s sensitivity to the movements in an index (i.e. S&P 500 for this article).  The index has a beta of 1.  A fund with a higher beta than the index has tended to have excess return, as well as excess volatility, related to the index.  For example, a fund with a beta of 1.10 would imply the fund has 10% better returns, while also 10% increased volatility compared to the S&P 500 index.  Rather than a portfolio with high risk and high return, clients should seek a portfolio with a lower beta and benchmark (or better) type of returns.   This indicates the portfolio keeps pace with (or outperforms) the S&P 500 index, while taking less risk.  For example, a portfolio with a beta of .80 indicated 20% less risk (1 - .80 = .20), while keeping pace or outperforming the respective index (S&P).  Over a three year time period, MFS Value has a beta of .85, with an annualized return of 11.32%.  The benchmark has a beta of 1.00, with a return of 8.62%.  Again, MFS Value demonstrated 15% less market volatility (1.00 - .85), while also outperforming the benchmark.   

 

Similar to beta, STANDARD DEVIATION helps us evaluate portfolio risk.  Morningstar defined standard deviation “as a statistical measure of the range of a portfolio’s performance.  When a fund has a high standard deviation, its range of performance has been very wide, indicating that there is a greater potential for volatility.”  The greater the standard deviation, the greater the volatility in of the portfolio.  Using the same fund and same time period mentioned above, MFS Value displays a standard deviation of 6.98% from the mean return of 11.32%.  During the same time period, the S&P 500 had a standard deviation of 7.79% from the mean return of 8.62%.  Again, MFS Value has a lower standard deviation than the S&P 500 index (i.e. lower volatility), while also outperforming the benchmark returns. 

 

Our three Nobel laureates divided the market between systematic risk (market risk) and unsystematic risk (non market risk).  Our third risk measurement – Alpha – measures the fund’s performance after adjusting for the funds systematic risk (as measured by beta).  Essentially, alpha is focused on removing the market risk and determining what additional value is provided by the money manager.  Yes, I’m exhausted trying to understand alpha too.  Alpha calculates if the portfolio manager is just taking much more market risk than the benchmark, or actually providing additional value at similar risk levels.  An alpha above 2.00 generally means the portfolio manager is worth ‘their salt’ and thereby the manager is providing additional value to the portfolio. Again, in our example MFS Value has an alpha of 3.02 against the S&P 500.

 

This article is not meant to confuse you with fancy investment terminology.  Instead, I suggest you spend equal time understanding your portfolio risk measurements, as you do understanding your return values. Merely looking at returns can provide a misleading sense of security in bull markets and a painful sense of disappointment in bear markets. 

 

We will be reviewing these risk measurements next month via a web seminar. Please email us, referencing ACT Dental, if you wish to participate.   James.dinardo@nmfn.com.  We are limited to 15 participants a seminar.  If more wish to sign up, we will provide additional dates and times.