Category: Your Money

Risk Adjusted Returns

Mutual fund

Image via Wikipedia

In my intro to calculating returns I had touched upon how to compare returns on different investments, you need to first adjust it for risk. There are three such measures that I consider important: alpha, beta and the Sharpe Ratio.

Alpha measures the ability of an investor to beat the market, thereby generating returns in excess of what might be possible by taking the same amount of risk. Essentially, an investment manager should not only avoid losing money for the client and should make a certain amount of money, but in fact should make more money than the passive strategy of investing in everything equally. Basically, you are paying your mutual fund for the alpha, compared to just buying the Nifty50 ETF.

Beta is similar to correlation (see: The Reliance on Correlation.) An asset has a Beta of zero if its returns change independently of changes in the market’s returns. A positive beta means that the asset’s returns generally follow the market’s returns. By definition, the market itself has a beta of 1.0. A stock whose returns vary more than the market’s returns has a beta whose absolute value is greater than 1. A stock whose returns vary less than the market’s returns has a beta with an absolute value less than 1.

And finally, the Sharpe ratio. The Sharpe ratio tells us whether a portfolio’s returns are due to smart investment decisions or a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is only a good investment if those higher returns do not come with too much additional risk. The greater a portfolio’s Sharpe ratio, the better its risk-adjusted performance has been. A negative Sharpe ratio indicates that a risk-less asset would perform better than the security being analyzed.

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Real vs. Nominal Returns

The One Rupee Banknote.

Image via Wikipedia

In my previous post about calculating returns, I briefly touched upon the notion of “risk adjusting” any projected returns to see if it makes sense compared to different investment options available. Today I’m going to discuss the biggest unavoidable risk of all: inflation.

Inflation is the erosion of value of money over time. i.e., as time progresses, the same Rupee buys less goods or services. We have all seen its effects first hand – I can’t think of single thing that has become cheaper over the years in India. So how does inflation affect investment decisions?

If you just took all your money and kept it in a vault, over a period of a year, you’ll get only 90% of it back. Where did the 10% go? Inflation took it (assuming a 10% annual inflation rate). Now imagine what happens if you socked away your money in a vault over a period of 10 years? How much will you get back then?

The rate of inflation plays a crucial role in calculating returns on investments. So important, in fact, that the way we calculated returns yesterday is called “nominal returns”. When you adjust nominal returns for inflation over the same period of time, you get “real returns.”

There are various measures of inflation depending on who it affects, but the most popular of them is the CPI – the Consumer Price Index. A good rule of thumb is to subtract nominal returns with the CPI to see how much you really end up making.

Different investments react differently to changes in inflation. For example, real assets, like real estate are supposed to be immune to inflation since their value is expected to rise along with it. Bonds perform poorly in an inflationary scenario because you get a fixed return. Stocks fall somewhere in between.

So its almost always a poor investment to keep cash in a vault. At the very least, your returns should at least match the rate of inflation.

Sunder’s List

Europe Simulator

Europe Simulator (Photo credit: wigu)

Stuff I’m reading this morning:

Customers parked their worries in December and spent, encouraged by discounts. Now, in the new year, reality has bitten again as concerns about jobs, wages and household costs reassert themselves. (JustStyle)

Not investing significantly in emerging markets is a form of gambling. (FT)

India Awakens to Need for Foreign Investment. Finally. (NYT)

Chinese banks and companies have cut their exposure to Europe. Local exporters are trying to sell more domestically or venture into emerging markets to cut their reliance on the euro zone. (Reuters)

QOTD: It wasn’t porn “but some real-life incidents caught on camera in Gulf countries”. (TOI)

Good Luck!

Calculating Returns The Correct Way

You often hear this whenever someone is trying to sell you something: “Don’t worry, this investment will double in 5 years” or “You will not lose money on this.” But how can you tell if it’s the right investment for you? When you look at any investment, be it real estate, gold or stocks, you need to consider two things: risk and reward.

So lets dissect the first statement: what does doubling in 5 years really mean? Your cashflow looks something like this:

imageSpend 100 now, get 200 back 5 years from now. If you run this through the XIRR function on Excel, it shows that your reward is a 19% Internal Rate of Return. Sound good? Would you take this rate of return on gold? Yes. How about teak plantations? Perpetual motion machine?

Here’s where risk plays a part in helping you gauge whether something is a good investment or not. Gold, at a 19% IRR is way better than land at the same IRR. Land at 19% is better than teak plantations at the same rate and so on. The way you figure out if you are being compensated for the risk you are taking is by comparing it with the risk-free rate for the same time period. For example, if you keep the same money in a bank fixed deposit, you’ll earn about 9% for 5 years. So the additional risk that you are taking to get to the 19% return is worth 10%.

Negative returns are those that grow less than the base rate. Getting 5% when the risk-free rate is 9% is losing money. If a stock goes up by 10% while the NIFTY 50 goes up the 12%, that’s a bad stock pick. You always need to compare the returns you get to a risk-free or passive investment in order to figure out if it makes sense. In order to compare investments across different areas, people smarter than me have come up with a variety of metrics (each of which are flawed in its own unique way) and the concept of “risk adjusted returns” which I will attempt to explain in layman terms in the future.

Tomorrow’s post will discuss the effect of inflation and transaction costs on real returns. If you have any questions, please email me:

Sunder’s List

Stuff I’m reading this AM

Shipping rates have gone negative! Yes, some customers are getting paid to hire ships. (ZH)

Its time Greece said good-bye to the Euro. The story is getting dragged too long and is not in the best interests of the Greeks. The Germans had their shot at taking over Europe 70 years ago and they blew it. Get on with your lives already. (FT)

Oh the French! They championed the EU to tie down the then recently unified Germany with “silken cords”. Now they have to face the awful truth that this elegant strategy has blown up in their faces, enthroning Germany as undisputed hegemon. (Telegraph)

The end of wall street? (NYMag)

Here’s  cool fantasy vs. reality graphic:



Enjoy your day!