Not all returns are created equal.

The market is flooded with all sort of Investments like Mutual Funds offered by banks and mutual fund companies with almost everyone offering the same asset class investments.  Between different banks offering similar investment funds, you may wonder why one bank offers higher return over its peers.  Naturally, you will be enticed and even persuaded to invest in a product which offers the “highest” absolute returns.  Be warned though!  Be very alert that by itself, the historical absolute return of an investment can be quite misleading when used as an indicator of future performance.

www.flickr.comphotos

Chasing after the return only tells half of the story.  You cannot simply rank investments from highest to lowest by using the return figures.  It is more important to get good risk-adjusted return as this is a much better barometer.

ABSOLUTE RETURN
In simple terms, absolute return is the gain or loss of a fund in a particular period, quoted as a percentage.  This is what you see published in broadsheets and disseminated across different media forms.  These figures are what entice ordinary investors.

RISK-ADJUSTED RETURN
On the other hand, risk-adjusted return refines return by measuring how much risk is involved in producing that return.  When comparing two or more potential investments, an investor should always compare the same risk measures between different investments in order to get a relative performance perspective.

SO WHAT?
You may then wonder, what’s in it for me?  Absolute return is the more obvious measurement of a fund’s performance.  How do I know what is my risk-adjusted return?  How do I know how much risk is involved for the return I’m getting?
In basic terms, risk-adjusted return is computed as:

Risk-adjusted return = Absolute return over Volatility  

In layman’s term, volatility refers to the fluctuations in the fund’s Net Asset Value (NAV) per unit or NAV per share.  The rule of thumb is the higher the volatility, the riskier the investment

GOLDEN RULE

www.flickr.comphotos26373139

When comparing two funds with the same absolute return, a fund with a higher-risk adjusted return is actually a better option than another fund with a lower risk-adjusted return because a higher ratio means higher reward per unit of risk taken.

To illustrate, take the story of Jane who needs to go to another town.  She has two options: a.) take a rough road with a shorter route, or b.) take a paved road which will mean a longer travel time for Jane.  At first look, both alternatives might come across as equals, providing the same absolute return, which is to reach the other side of town.  However, taking into consideration the risks involved in taking the rough road, option B can actually provide a greater risk-adjusted return.

YOU CHOOSE
In choosing a fund, remember to not just focus on the financial reward.  It is also important to consider the risks involved in achieving your desired return.  Don’t be blinded by RETURNS ALONE.  Remember to ask yourself, “How much risk am I willing to take to reach my desired reward?”

(Sources: BPI Asset Management Research, BPI Asset Management Weekly Market Update and Outlook, BPI Investment Funds Daily Monitor, Bloomberg, Investopedia.com)
Disclaimer: Investing involves substantial risk. Neither the author, the publisher, nor any of their respective affiliates make any guarantee or other promise as to any results that may be obtained from using this blog. No subscriber should make any investment decision without first consulting his or her own personal financial advisor and conducting his or her own research and due diligence, including carefully reviewing the prospectus and other public filings of the issuer. To the maximum extent permitted by law, the author, the publisher and their respective affiliates disclaim any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations in this blog prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses.