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The Tortoise, or the Hare?

October 28, 2009

Money-Guy 10-27-2009

Today’s show is on a topic that I feel is very easy to understand but, for some reason, very often overlooked. While overlooking this seemingly small concept may not seem like a huge deal, the impact it can have on your investment portfolio as well as your ability to reach your long term goals in monumental!

GoodTimes

Take a look at the chart above. If I were to tell you that the blue line and the pink line represented two different investments and then I asked you which investment you would rather participate in, what would your answer be? My hunch is that you would say the blue line. Am I right? Both lines started with the same initial investment ($100,000). Both investments appear to have done well. But, the blue one appears to have a significantly higher end value (a difference of almost $26,000). So why in the world wouldn’t you pick the blue investment? The simple answer… you don’t know enough about it.

The concept I am alluding to is risk-adjusted return. Investopedia defines risk-adjusted return as:

A concept that refines an investment’s return by measuring how much risk is involved in producing that return, which is generally expressed as a number or rating. Risk-adjusted returns are applied to individual securities and investment funds and portfolios.

Now don’t get me wrong, this concept can get very technical and complex. We could talk about alpha, beta, r-squared, standard deviation, and the Sharpe ratio. However, I don’t want you to get bogged down in the jargon. Rather, I want you to understand the concept and recognize how to use it to optimize your investment portfolio. Look again at the chart at the top of the page. I wanted to paint a very specific picture for you. In other words, I cherry-picked a period in the market where there was a reward for taking on additional risk. Now let’s take a look at a more neutral picture of the markets:

GoodandBad

Quite a different picture, huh? Now if I were to ask you which investment you would prefer, would your answer have changed? It is pretty clear to see that, even though when the market is rockin’ and rollin’ the blue investment significantly outperforms the pink, over the long-term on a risk-adjusted basis, the pink investment may be the one to better assist you in reaching your goals.

As you listen to the show, I will explain these concepts  in more depth and even provide you with a very simple calculation to  measure the level of risk you are taking with your investments. As always, please enjoy!

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