Beat the Market with Less Risk than You Thought Possible

By Nathan Slaughter
December 29, 2009

The financial waters are always choppy, and during bear markets you might find yourself wondering if there's anything you can do to keep your portfolio on an even keel, short of stuffing money under the mattress. After all, risk and reward always go hand in hand. Yet, that doesn't mean that you can't take steps right now to help keep that risk to a minimum -- while leaving your expected rewards unchanged.

Most of us naturally gravitate toward funds that have produced superior historical returns. However, not everyone stops to evaluate just how much risk shareholders were subjected to in order to achieve those returns.

For the sake of illustration, consider a fund that delivered stable returns of +8% in year #1, +8% in year #2, and +8% again in year #3. Now, imagine another fund that posted a gain of +6% in year #1, a loss of -2% in year #2, and then a gain of +21% in year #3.

Both would have turned a $10,000 investment into nearly $12,600 over the three-year period, for a cumulative gain of +26%. However, which of the two would you rather own? Most likely you would take the first, because it provided a much smoother path to the exact same destination.

Of course, in the real world it's unrealistic to expect to encounter such a choice. But the underlying premise remains the same. If two funds with similar fees and portfolio composition provided the same returns, but one took a more direct route and experienced narrower price swings along the way, then it is probably your best bet.

While it only makes sense to avoid overly volatile funds, in practice many investors don't even bother to conduct more than a cursory background check -- looking up historical returns is easy; evaluating risk metrics can be trickier. However, it only takes a few minutes to get a grasp on the basics -- which I'll explain in plain English below.

When attempting to mitigate the impact of a volatile market, carefully consider each of the following:

Beta -- Beta is a useful way to gauge volatility and determine whether or not a fund moves in tandem with an underlying benchmark. A beta of 1.0 means a fund marches perfectly in lock-step with the benchmark index, while anything above or below 1.0 implies the fund typically moves faster or slower. For example, a fund with a beta of 0.5 against the S&P 500 is generally half as volatile as the index and can reasonably be expected to drop just -2% in a period when the market loses -4%.

Keep in mind, a properly diversified portfolio has little to do with the number of funds inside it, but rather the way those funds work together. Whenever one group of securities is moving down, there should be another somewhere else that is moving sideways, or even up. Evaluating fund betas and holding a variety of different asset classes with low correlation can be a great way to smooth out the inevitable bumps in the market.

Standard Deviation -- Standard deviation is another widely used measure of volatility. Essentially, standard deviation tells us how widely a security's returns are scattered around its average return. Clearly, a fund that is up +40% one year and down -22% the next is more volatile (and thus has a higher standard deviation) than one that gains +12% one year and loses just -6% the next.

But remember, different asset classes will have different standard deviation ranges, so it's important to compare figures from within the same category. As a rule of thumb, standard deviations for small-cap stocks, large-cap stocks and bonds have averaged roughly 16%, 12%, and 4%, respectively, over the past five years.

Sharpe Ratio -- The Sharpe ratio is calculated by determining a fund's excess returns over the risk-free rate (usually the rate U.S. Treasuries are paying) and then dividing by its standard deviation.

Any fund can outperform the risk-free rate, but all must take on a certain degree of risk to do so. By factoring standard deviation into the equation, we get an idea of not only a fund's raw returns, but also how the manager has done on a risk-adjusted basis -- the higher the Sharpe, the more impressive the performance.

For example, assume that a fund with annualized returns of +14% over the past three years has a standard deviation of 9%. If the risk-free rate over this time frame was +3%, then the fund would have a Sharpe ratio of 1.22. Written out, that calculation would be: ((14%-3%)/9%).

#-ad_banner_2-#By contrast, another fund might have a higher return of +15%, but also a much larger standard deviation of 13%. In this case, the second fund would have a Sharpe ratio of just 0.92. Even though it produced slightly better returns, investors weren't adequately compensated for the additional risk.

Generally speaking, any Sharpe ratio above 1.0 is considered good and anything greater than 2.0 is exceptional.

Alpha -- Alpha is considered by many to be the Holy Grail for professional money managers and the best barometer of whether or not they earn their keep. The actual calculation can be somewhat complex. But in simple terms, alpha captures the excess risk-adjusted returns that a fund earns above that implied by its beta.

In other words, alpha gives us an idea of how much of a fund's returns can be explained by savvy investment decisions, beyond those that come from just drifting with the overall flow of the market.

Alpha and beta work hand in hand. As a simplified example, if a fund's beta is 1.2 relative to the S&P 500 and the index posts an annual return of +10%, then we can expect the fund to have delivered a gain of +12%. However, if the actual return was higher, say +15%, then the manager clearly added value -- and alpha measures that value.

Think of alpha as a way of measuring "bang for the buck", the higher the figure, the more value a manager brings to the table for shareholders. But remember, even alpha can be volatile and have its own standard deviation.

Like other financial metrics, risk and volatility measures such as beta and standard deviation have their flaws and shouldn't be used in isolation. However, when taken together, these data points can present an accurate depiction of whether or not a fund's shareholders are being adequately rewarded for the risk they have assumed.

With all of this in mind, you should always take volatility and risk-adjusted performance into account when analyzing any mutual fund or ETF.

Finally, along with the guidelines above, it's worth scrutinizing other factors that might impact volatility: Does the fund use portfolio leverage? Do its managers make aggressive sector bets? What percentage of assets is stashed in the top ten holdings?  These other factors, which we explore in greater depth in a variety of other articles on this web site, will give you a better sense of the type of risk you're taking, and they'll give you a much better chance of beating the market with less risk than you thought possible!