Column: financial exploration
One of the reasons I enjoy the opportunity to write this column is that the writing process forces me to think through, in words, many things that I do or consider in my investment decisions that are so second nature to me that I do not give them much conscious thought – sort of like tying my shoe laces. Managing investment risk is at the very heart of my work, yet from an operational viewpoint, I do not give it much conscious thought. The processes I have developed for making buy, sell or hold decisions are so consistent and so automatic that I really do not have to think about them very often. When I do think about them, it is usually because I need to explain the elements of my investment decision process to someone who does not have a technical understanding of investing.
I have decided to explain a very important investment risk management concept called “Risk Adjusted Return on Investment.” Any of you who are active, but novice, investors need to understand it if you want to make better, safer, more informed and profitable investment decisions.
Let me begin my explanation by asking you to imagine that you are an explorer, living about 200 years ago in the American Southwest. You find yourself at the northern head waters of the Colorado River. You need to find a way to move yourself and your belongings down the river to end where it empties into the Gulf of California. You need to reach your destination in a fixed amount of time. You have been told truthfully that the river is very turbulent, even life-threatening, with lots of waterfalls, whirlpools, white water rapids and jagged hidden rocks just below the surface. But if you are going to have a chance of reaching your destination, you must find a way to get down the river.
You meet two Native Americans who tell you that they can guide you to your destination. But they have very different methods of navigating the trip. One of the guides tells you that if you just put yourself and all your assets into a very large, stoutly built canoe, you have about a 50 percent chance of reaching your destination at the other end within your time limits. You just have to ignore the dangers of being on the river, close your eyes and hold on for dear life.
The other guide quietly disagrees. He tells you that the safer way is to learn to anticipate the dangerous points on the river, pull into shore and carry yourself and your belongings overland until you reach a safe stretch of water to continue your trip downstream. He tells you that doing this reduces the risk of loss to you and your assets. At the same time, you will reach your destination within your time limits. That is what understanding Risk Adjusted Return on Investment will help you to do with your investment portfolio.
The concept of RAROI compares the annualized ROI for a risky asset class such as a stock index or mutual fund, under conditions of 100 percent market risk, to the annualized ROI realized by investing in a relatively riskless asset class such as 90 day U.S. Treasury Bills. The RAROI is the return realized by subtracting the annual interest rate of a relatively secure investment, such as 90-day U.S. Treasury securities, from the annual return on a common equity index such as the New York Stock Exchange Composite Index. An an example, the unadjusted rate of return for the NYC-I over the last 12 months was 20.8 percent. That is the buy and hold 100 percent equity market risk exposure ROI. The 123 month return for 90 day U.S. Treasuries was 4.7 percent, so the risk adjusted return for the NYC-I was 20.8 percent minus 4.7 percent, or 16.1 percent.
The traditional approach to reducing investment portfolio risk is invest in different assets classes with varying degrees of price volatility to achieve a target RAROI. The problem with that approach is that it assumed you cannot achieve your investment goals unless you keep your Boat of Assets 100 percent committed to riding down the river, even though devotees of that approach will reluctantly acknowledge the 40 percent long term probability of failure to reach your destination.
That is the greatest advantage of a technically sound combination of asset allocation and market timing. You avoid the white water rapids, the water falls, the whirlpools, and you reach your destination on time, and in one piece. In fact, you will probably achieve your goals faster, even exceed your expectations with a higher RAROI.
Clifton Maclin is an SEC-registered financial services representative in Carson City.