Most people I come across find choosing a Kiwisaver fund or investment a complex and potentially scary decision. However, I’ve found that understanding some basics around how to analyse risk-adjusted returns can hugely simplify the decision process and remove the anxiety.
In this comprehensive guide, we'll dive deep into the world of risk-adjusted returns, exploring how investors can evaluate investment performance beyond simple returns.
You'll learn how to assess investments more intelligently, protect your portfolio, and make more informed financial choices.
So, what are Risk-Adjusted Returns and why do they matter?
Risk-adjusted returns represent a sophisticated approach to evaluating Kiwisaver and investment performance that goes beyond simple percentage gains.
Unlike traditional return measurements, this method considers the amount of risk taken to achieve those returns.
Imagine two Kiwisaver funds: one that generates 10% returns with minimal volatility and another that also generates 10% but with extreme price fluctuations. Risk-adjusted returns help investors understand which investment is truly more valuable.
Key Components of Risk-Adjusted Returns
1. Understanding Kiwisaver Fund Risk Metrics
Risk-adjusted returns are fundamentally about balancing potential rewards with potential dangers. We use sophisticated metrics to evaluate how much return a fund is generating relative to the risk it is assuming.
These metrics provide a more nuanced view of investment performance, allowing for more intelligent decision-making.
The primary goal of risk-adjusted analysis is to normalise returns across different asset/investment opportunities. By considering factors like volatility, standard deviation, and potential downside, you can make more informed choices about where to allocate your capital.
Professional investors rely on multiple risk-adjusted metrics to create a comprehensive view of investment potential. These metrics help them compare investments that might appear similar on the surface but have dramatically different risk profiles.
Understanding these metrics requires a combination of mathematical knowledge and financial insight. As a Kiwisaver user, we recommend looking beyond surface-level returns and dig deeper into the underlying risk characteristics of your investment.
Key points:
Risk-adjusted returns provide a holistic view of investment performance
Metrics help normalise returns across different investment types
Professional investors use multiple risk assessment tools
Mathematical and financial knowledge is crucial for accurate analysis
Comparing risk-adjusted returns reveals hidden investment insights
2. Calculating Risk-Adjusted Performance Measures
Calculating risk-adjusted returns involves several sophisticated mathematical approaches. The Sharpe ratio is perhaps the most well-known method, which compares an fund's excess return to its standard deviation. This helps you understand how much additional return you're receiving for each unit of risk taken. We are able source this measure for our clients.
Another critical measure is the Treynor ratio, which evaluates returns relative to systematic market risk. Unlike the Sharpe ratio, it uses beta instead of standard deviation, providing insights into how a Kiwisaver or investment fund performs compared to the broader market.
The Jensen alpha is a more advanced metric that measures an investment's performance against a expected return based on the capital asset pricing model. It helps investors identify investments that are outperforming or underperforming relative to their expected risk level.
Modern portfolio theory has revolutionised how investors think about risk and return. By understanding these calculation methods, investors can make more sophisticated investment decisions that go beyond simple return percentages (see video here).
Morningstar offer select advisers a quarterly risk versus return chart that compares the Kiwisaver and fund managers performance across New Zealand.
As part of our analysis for clients Kiwisaver and fund management, we use these metrics. An example of how they can be used is below:
Key points:
Sharpe ratio compares excess returns to standard deviation
Treynor ratio evaluates returns relative to market risk
Jensen alpha measures performance against expected returns
Modern portfolio theory provides advanced risk assessment techniques
Multiple metrics offer a comprehensive investment evaluation
3. Practical Applications in Kiwisaver and Investment Fund Strategy
Risk-adjusted returns are not just theoretical concepts but practical tools for real-world Kiwisaver and investment fund management. Institutional investors, hedge funds, and sophisticated individual investors (you) can use these metrics to build more robust portfolios that can weather market volatility.
By prioritising risk-adjusted returns for your Kiwisaver, you can create a more balanced and resilient investment strategy. This approach helps mitigate potential losses while still pursuing meaningful growth opportunities.
Diversification becomes more strategic when viewed through the lens of risk-adjusted returns. You can identify a Kiwisaver or investment fund that provides complementary risk profiles (they aren’t all equal), creating a retirement savings vehicle that is more stable and potentially more profitable over time.
Technology and advanced analytics have made risk-adjusted analysis more accessible than ever before, but you’ll need to team up with a trusted adviser to access them (schedule here).
“You now have powerful tools at your finger tips to evaluate and optimise your investment strategy with unprecedented precision.”
Key points:
Risk-adjusted returns guide practical investment decisions
Institutional investors rely on these sophisticated metrics, you can too
Diversification becomes more strategic and intentional
Advanced technology enables more precise risk assessment
Balanced portfolios can be created through careful analysis
4. Common Mistakes in Risk-Adjusted Return Analysis
Many investors make critical errors when attempting to analyse risk-adjusted returns. The most common mistake is relying too heavily on a single metric or misunderstanding the context of these calculations.
Overconfidence can lead investors to misinterpret risk-adjusted metrics, assuming past performance guarantees future results.
It's crucial to understand that these measures provide insights, not absolute predictions.
Another significant error is neglecting to consider the specific investment context. Risk-adjusted returns can vary dramatically across different asset classes, market conditions, and investment timeframes.
Investors must continuously educate themselves and remain adaptable. The financial landscape is constantly evolving, and risk assessment techniques must keep pace with changing market dynamics.
Key points:
Avoid over-reliance on single risk metrics
Understand the limitations of risk-adjusted analysis
Context is crucial in interpreting performance measures
Continuous learning is essential for effective investing
Adaptability helps navigate changing market conditions
Conclusion
Risk-adjusted returns represent a powerful approach to understanding investment performance. By looking beyond simple percentage gains and considering the underlying risk characteristics, investors can make more informed and strategic financial decisions.
FAQs
Q: What is the most important risk-adjusted return metric?
A: The Sharpe ratio is widely considered the most comprehensive risk-adjusted return metric, but no single measure tells the complete story.
Q: How often should I calculate risk-adjusted returns?
A: Regular review is recommended, typically annually, depending on your investment strategy and portfolio complexity.
Q: Can individual Kiwisaver investors use risk-adjusted return analysis?
A: Absolutely! Our tools and investment platforms now offer risk-adjusted return calculations for individual investors.
Q: Do risk-adjusted returns work for all types of investments?
A: While most effective for traditional financial assets, the principles can be applied across various investment types with appropriate modifications.
Q: How significant are risk-adjusted returns compared to total returns?
A: Risk-adjusted returns provide crucial context that total returns alone cannot, offering a more nuanced view of investment performance.
Thanks for reading!
Chris George | Financial Adviser