Compared to what? Part 2: Your risk-adjusted return

In Part 1 of our series on assessing performance, we looked at outcome-based investing, or how your investments performed in their function of helping you achieve your personal financial goals.

The second part in our series examines something core to our investment philosophy at Newport, looking at not only the return itself, but rather the risk-adjusted return. In other words, what level of risk did you take to earn your investment return?

The return numbers are only half of the performance equation. The other half is risk. This is probably the single most-overlooked factor in how retail investors typically assess investment return and the most common reason investors get into trouble. Many investors are unaware of the risks they are taking in their portfolio. And many take more risk than is necessary to reach their personal goals (see Part 1). For example, we have seen so-called “income-balanced” portfolios, designed for conservative investors, with an asset mix of 75% equities! A portfolio that delivers an eye-popping investment return one year may be the next year’s dog. Even if you can stomach the volatility, it may not be in your best interests.

That’s because volatility can wreak havoc if an investor is withdrawing capital from the portfolio. It is entirely possible for two portfolios to achieve the same level of return over the long term, but because of different volatility profiles, they have totally different outcomes. For example, let’s say two investors each earn an average of 7% over 25 years. They start with the same amount of capital and withdraw the same amount each year to provide for living expenses. The only difference is the amount of volatility in their portfolios. The investor with a volatility measure equal to that of the S&P/TSX Composite Index (20%), for example, would have a 30% chance of running out of money at the end of 25 years. Whereas the investor with a more modest volatility measure (5%) would have zero risk of outliving their money.

At Newport, we structure our client portfolios to achieve steady performance, with fewer dramatic swings. Our stated goal is to capture 75% or more of the gains when a market is on the upswing, while experiencing only a quarter or less of the market’s decline. In summary, we recommend investors take time to understand what is behind their performance numbers – especially the risks taken to achieve them.