Why investors should balance risk and return

Better a poor horse than no horse at all. You probably know this saying. It advises you to choose a small but safe benefit over a large but uncertain benefit. This can also be a valuable guideline for investors.

Because they are regularly faced with such a dilemma: Am I satisfied with a return of, for example, three percent a year and should I not fear for my capital? Or do I strive for a return of e.g. 25 percent a year that I have to take significant risks on my assets?

In order to be able to answer such questions correctly, it is advisable to compare risk and return. Or to put it another way: Calculate a risk-adjusted return.

It sounds like brown bread for breakfast, but it can certainly be fun. What do you need for this? Two measurements, one for return and one for risk. To get a value for the return, one either estimates the return over the next 12 months or uses the average return from the previous one.

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With Dax, it would look like this: The average return over the past ten years was 8.3 percent per year. If you believe the consensus forecast from the experts, who see the leading German index of 12,170 points by the end of 2019, you would get a return of 11.8 percent. Of course, you are also allowed to make your own estimates.

Note annual volatility

These values ​​must now be compared with the risk. For this, it is advisable to take the annual volatility. This indicator describes the fluctuation range around the mean. It is published daily by the German stock exchange, for example, and is currently 16.2. This gives a return on Dax per unit of risk (R / RE) of 0.51 per cent, based on the average historical return, and 0.73 per cent, based on the experts’ return estimate.

Let’s take this as a plan for other investments: A global equity investment with an assumed return of 8.3 percent, like Dax, gives an R / RE of 0.65 percent. That is 0.14 percentage points better than an investment in the leading German index. And this superiority can also be well explained.

Because with a global investment in equities, the risk is spread much better across regions and sectors, a better risk-adjusted return can be achieved under the same return. Since the average return on global equities was actually 11.2 percent, the figure even improved to 0.87 percent.

The comparisons with fixed income investments are really interesting. The ten-year Bund, for example, has an R / RE of minus 0.08 percent. It should therefore be excluded from any investment consideration. Looking at the United States, the S&P 500 has an R / RE of almost 1 percent. The risk of possible changes in the dollar exchange rate is already included.

One investment stands out in this beauty contest for the best risk-adjusted returns with a score of 3.6 percent. It is a two-year government bond with a yield of 2.6 percent and a volatility of 0.8. However, before turning your portfolio upside down, take a deep breath.

It is useful to see different investments through the lens of risk-adjusted returns, as it makes it possible to establish a certain degree of comparability. However, the methodological shortcomings should not be ignored. After all, the concept is based on estimates of risk and return. However, both can change very quickly.

Therefore, a diversification of assets across different asset classes is absolutely necessary. However, this does not change the statement that a global equity investment is preferable to an investment solely in German equities. At the same time, two-year US government bonds should be preferred over ten-year bonds.
The main disadvantage of the concept lies in its more long-term strategic orientation. However, the capital markets can change very quickly due to e.g. political events. The recent past has shown this in an impressive way.

For example, the US stock market lost 16 percent from its lowest level in December last year. This was the worst December show since 1901.

However, the high volatility that such phases entail should not be used as an opportunity to reduce positions. Rather, one can use such situations for purchasing if, after a critical examination of the causes of the losses, one can maintain one’s own price targets. So you can see that no concept can replace constant vigilance and constant commitment to the capital market. So be flexible.

Klaus Kaldemorgen, born in 1953, is one of the most well-known stock market strategists in Germany. For more than 35 years he has worked as a fund manager for DWS, where one of the investment funds even bears his name.

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