To illustrate the concept between optimizing versus maximizing, pick one of the following investment choices.
1) Investment that earns 15%
2) Investment that earns 12% but has half the risk of #1
Most people who are given this choice intuitively know to pick the second investment. Some however – the very “brave” few – say that they’d rather be in investment #1. This person is a maximizer, not a optimizer. There’s a big difference.
The optimizer takes into account the risk implied in the investment and bases their decision on a formula, not emotion. The maximizer wants to win big. They don’t care about some nerdy finance guy’s calculation of risk.
That brings us to how to calculate the risk-adjusted return when the investment choices are ambiguous.
I like to use the Treynor Ratio to calculate the risk-adjusted return. The Treynor Ratio is shown in the following formula:
Stock / Investment A: (Expected Return – Risk Free Rate) / Beta = Risk-adjusted Return
For example, let’s take a look at the risk-adjusted returns of both Cisco (Nasdaq: CSCO) and Microsoft (Nasdaq: MSFT).
CSCO has an expected 5-year compound annual return of 10% and a beta of 1.4.
MSFT has an expected 5-year compound annual return of 8% and a beta of 1.1.
The risk-free rate over the 5 year period is 1.95% based on the current 5-year T Bond.
CSCO: (10% – 1.95%) / 1.4 = 5.75% risk-adjusted return
MSFT: (8% – 1.95%) / 1.1 = 5.5% risk-adjusted return
You can see the risk-adjusted return is very close but the winner is CSCO in this case. This is using Treynor Ratio and it’s measuring systemic risk (risk that is non-diversifiable).
You could also use the Sharpe Ratio. The Sharpe Ratio is calculated the same exact way but instead of using the beta as the denominator, you use the standard deviation or sigma. This type of risk is called the total risk. This type of risk can be diversified away. So, if you have high standard deviation investments, you can diversify away by limiting allocation and investing in other lower standard deviation investments.
It’s important to use the same type of measurement when comparing risk-adjusted return so you can compare apples to apples. You can measure this risk-adjusted return with any investment; not just stocks.
We Live In A Multi-Factorial World
Risk-adjusted return is great to make comparisons regarding risk, but we live in a multi-variable multi-factorial world.
You have to take into account different asset types, valuations, qualitative nature. The risk-adjusted return calculation doesn’t take into account other variables. But that’s not what’s it’s for. It simply gives you a purely mathematically way to analyze risk.
The goal is not to compare other factors with this formula. Instead, I use it to give me the final decision based on two very similar assets. If the asset has the same P/E ratio, growth outlook, similar management, etc., I run it through the Treynor Ratio and Sharpe Ratio to see what the risk-adjusted return looks like.
Given the choice between two very similar investments, I will always pick the one with the higher risk-adjusted return.
The Maximizer swings for the fences. They’re always look for a way to make the most money possible, without regard to risk. They’re like Nero’s excessive risk-taking neighbor in Fooled by Randomness, Nassim Taleb’s first book in his Incerto series.
Nero (a thinly disguised Nassim Taleb) is a trader who lives next to another trader who he despises. Nero doesn’t make a ton of money but he understands risk. Nero’s neighbor makes money hand over fist but has no concept of risk. The neighbor is a flashy know-nothing who simply follows a financial trend to get rich. Well, he does get rich and buys a fancy car and a bunch of fancy-pantsy things, until he “blows up” his account and ends up leaving in disgrace.
Nero’s neighbor had no concept of how much risk he was taking, with by the way, money that wasn’t even his. He made a ton of money on the way up but quickly lost all of the money and then much more in a matter of days.
This brings me to an interesting, yet counterintuitive point: sometimes you can make the wrong decision but it looks like the right one.
For instance, a trader (Nero as an example) may choose to liquidate a certain position because of the inherent risk in the position. After Nero sells this investment, it continues to climb, leading his boss to think he’s an incompetent loser.
Did Nero make the right decision?
Some would say no, probably most of us would say he failed. But that may be the wrong answer.
You can’t tell what might have happened. Maybe liquidating the position was the smart move based on the risk profile.
That’s why I think you need to be more like Nero and less like all the Maximizer’s out there. Understand the risk involved in your investments. Most people think they’d be fine with a 30% drop in their investments until it actually happens.
Be An Optimizer
Given the choice between two investments, the optimizer will always choose the high risk-adjusted return. Be like Nero.
This is part of the entire thesis of this website. What I’m trying to do here is show soon-to-be retirees how to optimally allocate their assets. Your assets include your earned Social Security benefit, investment accounts, debt / leverage, reduction of tax-liability, physical assets.
Understanding risk-adjusted return is just one of the things you need to have a grasp on in order to optimize your retirement.
Every post I write should give you another way to optimize your retirement. I also call these retirement hacks: things that you can do that have a big impact on your finances in retirement. Things like carrying a mortgage in retirement and strategically maximizing your Social Security. These are two of about seven high-impact steps you can take to make sure you’re making the most out of your finances in retirement.
Do you ever calculate risk-adjusted return? Do you ask your financial advisor to consider the risk of your portfolio and make sure it’s suitable? What are your thoughts on risk in general?