Category: Your Money

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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.

Read More:
Sharpe: http://www.investopedia.com/terms/s/sharperatio.asp#ixzz1lmQd5BEB
Beta: http://en.wikipedia.org/wiki/Beta_(finance)
Alpha: http://en.wikipedia.org/wiki/Alpha_(investment)

Questions? Email me: abhi@stockviz.biz

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:

Spend 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: abhi@stockviz.biz