If you’ve ever googled the term “risk adjusted returns” and come away more confused than when you started, you’re not alone. The calculations that go into assigning risk to investments are complex, and can seem almost purposefully obtuse. So, while the average person might not be able to solve risk equations, it’s still important that they grasp the basic concept of risk adjusted returns.
To put it in plain English: risk adjusted returns refer to the fact that you can’t just look at how a single investment fund performed, and call it good or bad. You also have to compare the returns gained from that fund to those gained by a zero-risk fund, and determine if the risk taken by you, the investor, was worth it.
In other words, if a mutual fund returned 8% last year, but a similar investment in treasuries (considered zero risk) would have returned 3%, your risk adjusted return for that mutual fund is 5%. The larger the gap in returns between your investment and a zero-risk investment, the larger the potential for returns OR losses.
Determining the right kind of risk adjusted returns for you should be a joint effort between yourself and your financial advisor. Here are the things you should be discussing together.
Market Volatility
Nobody wants to think about the market taking a sudden nosedive, but a good financial advisor will always have that possibility in mind. Looking at history tells us that the market does grow over the long haul, but there are sometimes recessions that slow that growth down considerably or even decrease the value of your accounts for a period of time.
Generally speaking, the further away you are from retirement, the more you can absorb the impact of a recession or a market downturn. A 30-year-old with a 401(k) has plenty of time to allow the market to bounce back before they reach retirement age. However, a 61-year-old could be drastically affected by the same circumstance.
No matter what age you are, your financial advisor should be able to clearly explain to you how market volatility would affect your specific investments. If you do not like what you are hearing, or if you feel too many risks are being taken, you should bring that up right away. A financial advisor making risky investments on your behalf may not be working in your best interests.
Creating Balance
A balanced investment portfolio will never rely too heavily on a single aspect of the market. This practice is to help avoid too much loss, should one area of the market perform poorly. Ideally, your investments will be spread out across stocks, bonds, real estate, cash, and perhaps even some collectibles or commodities.
Of course, balancing a portfolio is not a once and done event. Your financial advisor should periodically revisit your portfolio and discuss your rebalancing options with you. A skilled advisor will know when it is appropriate to move some of your money over to a type of investment that is performing well, but they will also know when to move it back into balance.
Your Investment Objectives
A financial advisor simply cannot work in your best interest if they have no idea what your personal investment objectives and goals are. In fact, it should be the first thing you discuss upon meeting with them.
They should have a very clear picture of where you want your money to go, and what you need it to do. Are you saving for college in addition to your own retirement? How do you intend to spend your retirement? At what age do you plan to retire? Do you hope to pay off any mortgages or other loans prior to your retirement date? The answers to all of these questions and more must be understood by your financial advisor before they can determine what kind of risk-adjusted returns are appropriate for you.
Sure, retirement might still be 15 years off, but perhaps your child’s college tuition will begin next year. If you are involved in too many risky investments at the wrong time, you could sustain a loss so substantial that it might leave you scrambling to afford one of your main investment goals.
Your Personal Risk Tolerance
As I have mentioned already, timing has a lot to do with your personal risk tolerance, however it is not the whole story. The conventional wisdom says that the further off you are from retirement, the more aggressive (and therefore risky) your investments should be, while people closer to retirement should switch everything into conservative and low risk funds. But is that really true for everyone?
Another huge factor in determining your personal risk tolerance is your net worth. People who have enough money to live comfortably off the interest they make from their retirement investments might very well have a higher risk tolerance, because they have a much larger cushion in place. Of course the opposite is often true for those who don’t have a lot of personal wealth. In their case, risk is nearly intolerable, because a bad investment could mean their retirement funds run out too soon.
An often overlooked aspect of risk tolerance is your personal experience with investing, and the experience of your financial advisor. If you have been investing for decades and feel that you know the market pretty well, you may have developed a larger risk tolerance as a result. Someone fairly new to the idea (whether they are professionals or not) might want to stick to the safer path until they have some experience built up.
Here are the bottom lines to remember: firstly, it’s your money, and if you’re uncomfortable with the risks being taken, you are well within your rights to speak up – and secondly, your financial advisor should always be working in your best interest. Don’t forget that not every financial advisor is a fiduciary, meaning not every financial advisor is legally bound to make the best possible investments on your behalf. If you and your advisor are not talking about many of the items discussed in this article, it might be time to look elsewhere.
Retirement planning has many moving parts, and risk adjusted returns are part of it all. For a more detailed explanation of things that can affect your retirement savings and investments, read our free guide called “Living in Retirement.”
