Today I’m starting a major personal challenge. I’m going to tackle a topic that typically makes investors’ eyes glaze over. It’s a topic, however, that’s too important to be ignored. I’m talking about the concept of risk-adjusted returns.

The personal part of the challenge is to make sure that I present the information in a way that is easy to understand and that makes an impact on you. I believe that this topic is easily the most misunderstood topic in investing and the most important thing you’re likely overlooking in your own investing.

I’m going to be covering this topic on a regular basis for at least the next month or two. As part of my exploration, I’ll be covering individual newsletter portfolios and how some newsletters have done a better job than others at delivering above average risk-adjusted returns.

Today, however, I’m going to start with the basics. I’m going to show you how risk-adjusted returns have played out in two very well-known stocks – Microsoft (MSFT) and McDonald’s (MCD).

MSFT and MCD are two of my personal favorite stocks right now. In full disclosure, I own them both.

The most obvious thing that investors focus on when evaluating the performance of stocks is the percentage gain in the price.

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If we look at the price performance over the last 6 years for MSFT and MCD, we can see that MSFT is the clear winner over MCD. MSFT is up 180% and MCD is up 130%. Case closed. Right?

Not so fast.

What I would like to draw your attention to is how much less volatile MCD has been than MSFT in the past 6 years. Looking at the blue MCD line, you can see that the ups and downs in MCD were much less dramatic than the ups and downs in the black MSFT line.

This relative lack of ups and downs in MCD versus MSFT is exactly what our proprietary Volatility Quotient (VQ) measures. The current VQ on MCD is 11.2%. The current VQ on MSFT is 18.1%. Based on VQ, MSFT is 62% more volatile than MCD!

[TradeStops tip: One quick way to find the current VQ on your favorite stock is to go to the Research section of TradeStops and run the Stop Loss Analyzer on your favorite stock in Single Stock mode. To quickly find VQ’s on stocks you already own, you can add VQ% as a column to your Portfolio views.]

So yes, MSFT has delivered better gains over the past six years than MCD but it has done so at a cost – the cost of higher volatility.

Looking at this particular case might tempt you to believe that you would always be willing to accept higher volatility for greater gains, but believe me, that isn’t always the case. Let me illustrate this fact to you by zooming in a couple of sections of our comparative chart above.

Consider how you might have felt about the extra volatility of MSFT as of the end of 2011 …

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Your investment in MSFT was up 25% as of January 2011, gave back nearly all of those gains by June 2011 and then thrashed violently around for the next six months to end 2011 up just 15%. MCD, on the other hand, rose to a 22% gain by December 2010, only corrected 10% and then started a steady march to nearly 60% gains by the end of 2011.

Even after three full years, MCD still had eked out more gains than MSFT … and MCD gave its investors a LOT less indigestion in the process.

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While higher volatility investments sometimes do deliver higher returns, there are a lot more bumps in the road! As investors we need to be prepared for those bumps … and we need to make sure we getting adequately compensated for the extra wear and tear on our emotions … and our portfolios.

Hopefully you now have the sense that extra volatility does have its costs. And, hopefully, you’re starting to have an interest in how to factor in such costs to your investment decisions.

Good! Now you’re ready to understand the concept of risk-adjusted returns.

There are numerous ways of calculating risk-adjusted returns but at the simplest level, all of these different methods answer one question – how many units of gain you can expect for every unit of risk you take.

Hang in there now … don’t let those eyes glaze over just yet.

Let’s take another look at our first chart – the percentage gain chart of MSFT vs. MCD over the past six years. Here it is again:

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In TradeStops our favorite risk metric is VQ%. We mentioned above the the current VQ on MSFT is 18.1% and the current VQ% on MCD is 11.2%.

We can calculate risk-adjusted returns on MSFT and MCD by simply dividing our units of gain (percentage gains) by our units of risk (VQ%). When we do that, we get a very different view of the performance of MSFT and MCD:

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What exactly is the above chart telling us?

After six years, MCD has delivered gains of 130% and has a VQ of 11.2%. If we divide our gains by our risk we get 130% / 11.2% = 11.6 units of gain for every unit of risk. We’ve earned 11.6% of gains for every 1% of the VQ on MCD.

MSFT, on the other hand, has delivered 180% gains and has a VQ of 18.1%. Dividing our gains by our risk gives us a current risk-adjusted return for MSFT of 9.9. We only got 9.9% gains for every 1% of VQ risk on MSFT.

When it comes to risk-adjusted returns, MCD has consistently outperformed MSFT over the six year period of our analysis. That’s clearly shown in the risk-adjusted chart above. Yes, MSFT has delivered bigger net gains than MCD but it also gave us a lot more pains along the way. MCD, on the other hand, has give us more gains per pain.

Make sense?

Savvy investors always think of reward and risk together. They never just focus on reward without considering the risk required to realize the potential reward. Risk-adjusted returns are a great tool for evaluating both reward and risk in our investment decisions.

I’ve only just scratched the surface of this important issue today. I’ve laid the foundation. My goal is to give every single one of our TradeStops subscribers the opportunity to become a savvy investor. I hope you’ll agree that we made some good progress today. There’s much more to come,

Richard_Signature
Richard M. Smith, PhD
CEO, TradeSmith
Founder, TradeStops.com