Exploring Risk Adjusted

Eric Falkenstein had a thought provoking post in which he outlined a type of risk adjusted strategy that I had not heard of before. If I understood him correctly this is his idea. The starting point seemed to be that assets with lower volatility tend to have higher returns over time than assets with higher volatility. This then lead to constructing an index comprised of the 100 stocks in the S&P 500 with betas closest to the 1.0 that is the market.

He has data and charts to show how this group outperforms and fills in some detail as to why this might be but that I wasn't specifically interested so much in a fairly broad swath of a major domestic benchmark index so much as taking the opportunity to explore some thoughts about risk adjusted concepts.

The simplest way to think about this is trying smooth out the ride as much as possible during the course of the stock market cycle. John Serappere has taken the concept and created what he calls the 75/50 portfolio which seeks to capture 75% of the market's upside but only 50% of the downside. He used to write about this and publish at IndexUniverse.com but it has been months since he published anything there.

There are many ways to incorporate a little bit of risk-adjustedness into a portfolio that are not particularly complex, many of which I write about and try to implement for clients. One way to think about risk adjusted returns is with an extreme example. Assume an investor seeks a market equaling total return of 10% (presumes the market will have a total return of 10% in a year). If this investor put 10% of the portfolio into a stock that went up 100% and left the other 90% in cash then the doubling of the one stock would result in a 10% return for the portfolio while only putting 10% of the portfolio at risk. The example is not realistic but I think does a good job of explaining the concept.

The simplest practical example is probably with dividends. There are all sorts of statistics floating around about how much of the market's total return comes from dividends with most studies coming up with 40-50% of the market's return coming from dividends. Dividends matter a lot except in years like 2008 where the market goes down a lot or 2009 where the market goes up a lot. Some may disagree with that point but if the market is dropping 38% in a calendar year then an extra 200-300 basis points that might accrue to a fully invested portfolio doesn't mean a whole lot in my opinion.

A point I have made before with dividends is that if the market were to have an average total return of 10% per year over some long period of time with the dividend of the index being 2% (this has been the case for a while now) then one is looking for 8% price appreciation. If the yield of the portfolio can be taken up to 3% then obviously the portfolio would only need price appreciation of 7% to get the total of 10% so the portfolio should not have to take as much risk (really the word volatility is better here) to get a 7% return as it would for an 8% return. Theoretically a safe 10% yield means there would not have to be any price appreciation.

Hopefully it is obvious you can't sellout for the highest yield possible. I seem to remember New Century having a pretty good yield for a long time but of course it eventually went bust. In a well diversified portfolio of individual stocks there would be some names that in normal times would yield 3.5-4.5% but now might yield 5-6% along with names where yield was not a consideration but offer access to some segment of the market believed to be important. The goal then becomes deriving a yield for the whole portfolio. That a portfolio yields 3.2% is more important than one component yielding 1% while another yields 5%.

An important focus on how I seek a good risk adjusted return is by paying attention to the various big picture things I write about so often (SPX above or below its 200 DMA, the yield curve, a sector's weight growing too large in the index). These indicators, IMO, tell when risks to equities are relatively attractive or unattractive. When unattractive then some sort of defense in the portfolio is in order.

Specifically I've talked about avoiding the full brunt of down a lot. I believe the market warns of trouble (add the 2% rule which I believe originated with Ken Fisher to the above) and when it does steps can be taken to make the portfolio look less like the stock market. For me this meant a double short ETF, selling a few things and having an overweight exposure to absolute return funds--all disclosed on the blog as I was implementing. If you can miss the full brunt and go along for the ride on the upside (even if you lag a little on the upside) then the risk adjusted numbers should be pretty good.

Another important aspect to this is to understand how much risk you need to take given the particulars of your situation. If you have been a good saver during your adult years then you probably don't need to be 100% equities with a volatile tilt. With the occasional exception a portfolio should take as little relative risk as possible--relative to your financial situation and volatility tolerances. Some may disagree but the idea of taking unnecessary risk or taking on more volatility than you actually need doesn't make a whole lot of sense. An example that might fit here is United Online (UNTD) which gets attention for having a very high yield. It has three business lines; one is non-highspeed ISP and another is a social networking site you have to pay for. The yield really is good and a cursory look makes me think they can pay it but what really are the prospects? You can decide for yourself but the point is pretty simple.

All facets of risk--analyzing it, building it correctly into a portfolio, everything--is crucial to understand, is very easily misunderstood and often used incorrectly. The amount of time one could spend on it is infinite which makes it such a fascinating topic.