Re-Thinking Investment Risk: Financial Advisors' Daily Digest

By SA Gil Weinreich :

Widows and orphans, in conventional investment industry thinking, don't go long emerging markets, but maybe they should.

That is one thought that is percolating after reading a truly provocative article called " The Paradox of Risk-Adjusted Returns " on today's SA by a brand-new contributor, Yuval Taylor. (Make sure to follow him so you can be sure to get his next contribution.)

Coming the day immediately after this forum entertained an active discussion about various portfolio theories , Taylor argues that they're all deeply flawed and does a lot of original thinking on how to shape a model that might better reflect investment reality. Here's a little excerpt:

Most money managers use the Sharpe ratio, which is a very simple and elegant measure: you take the average monthly return of your investments, subtract the risk-free return (inflation, ten-year treasury bonds, ten-year CD rate, what have you), and divide by the standard deviation of the monthly returns.Unfortunately, the results are frequently nonsense. Let's say you invest in (NYSEARCA: MINT ), the largest actively managed exchange-traded fund, which is comprised of short-duration investment-grade debt securities. MINT has an annualized variability of 0.53% (we'll use the five-year figures here). Compare that to the S&P 500 (NYSEARCA: SPY ), with a variability of 12.13%. Now let's look at their returns. Over the last five years, SPY has returned a total of about 80% (not annualized, but total). MINT has returned less than 5%. Inflation over the last five years is about 5.8%. In other words, if you invest in MINT, you don't keep up with inflation.Now which fund has a higher Sharpe ratio? MINT! Its five-year Sharpe is 1.63; SPY's is 0.96. Yes, MINT is less risky than SPY, but how can its

Taylor is thus pointing out the absurdity that our best models don't discern well between investment options that get the job done and vehicles like MINT that are suitable primarily for an investor's liquidity needs. He comes to the seemingly obvious conclusion that SPY's risk-adjusted return is actually superior. We just need to re-think risk. Taylor helps us do just that by pointing out the methodological flaw of risk measures based on daily, weekly or monthly fluctuations in securities prices despite the reality of the matter, which he eloquently states thusly:

There are only two times when the price of a security matters: the day you buy it and the day you sell it. The times in between are irrelevant.

Most investors seem not to act on the basis of this logic. But perhaps we can help them anyway if we can improve our models on the basis of Taylor's insights.

Let us know your thoughts in our comments section. Meanwhile, here are today's advisor-related links:

See also Target: Expect More And Pay Less, Following The Sell-Off on

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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