After reading “Model Stock Portfolio: Beating the Benchmark Is Nice, But a Loss Isn’t,” in the April 2009 AAII Journal, I think there are some errors in Figure 1. In particular, I think the three-year risk-adjusted return is wrong. As I understand it, the RiskGrade is higher for higher risk. If that is the case, then the risk-adjusted return for the Shadow Stock portfolio and the Vanguard Small Cap Index fund should be worse than unadjusted, not better! (For some reason, the risk-adjusted return for the Vanguard 500 Index fund was correctly calculated.)
This is frequently a problem with formulas that assume positive returns. When the returns are positive, everything works correctly but when they are negative, the formula must be modified. As a result, the risk-adjusted three-year return for the Shadow Stock portfolio would be –31.1%. Not a pretty picture!
Risk adjustment shouldn’t be a simple divisor. Taking more risk should penalize you, regardless of whether the market is going up or down. Risk-adjusted returns should always show that penalty. If they don’t, then they are misleading. It implies you could take much more risk during a downturn, because the risk-adjusted return is better (less negative).
Tom From Switzerland
James Cloonan Responds:
As you note, a portfolio that has a higher risk and lower return than the market is doubly underperforming. Why then should it have a higher risk-adjusted return? The nature of risk-adjusted return is that it looks at the return you would have received if you had reduced your holdings enough to make the risk equal to the market risk and put the balance in T-bills. Consequently, if you were doing that you would have reduced your portfolio holdings by one-third and put it in T-bills. This would have provided a lower portfolio loss than the market. If you are adjusting holdings to reduce portfolio risk then when the portfolio is doing better than the market, its risk adjustment will show a reduced advantage. But when the portfolio is doing worse than the market, the risk adjustment will provide a relative advantage.
It seems the problem is semantic—the difference is between risk taking and risk adjusting. Clearly, risk taking will lead to higher returns if you beat the market and lower returns (higher losses) if you don’t. The question is: How much of the gain/loss is due just to the additional risk and how much is due to stock selection? The purpose of risk-adjusted returns is to answer the question: If I adjust my portfolio by using T-bills or margin leverage so I have the same risk as the market, will my return be better than the market? If an investor has a specific risk preference, he can attain it either by finding a portfolio with exactly that risk or he can adjust the risk of any portfolio by combining it with T-bills or by leveraging (if the portfolio is less risky than he prefers). If an investor did that with the model stock portfolio, he would have done better (less bad) than the market. The Sharpe ratio would also be higher (less negative) for the model portfolio than for the market.
This article misses the most important and obvious preventive measure: Keep your advisor and your money separate. If you wish, grant your advisor trading authority via a limited power of attorney, but keep your money in a separate firm. This assures your advisor’s results are transparent and your money can’t be siphoned off for illicit purposes. Point 2 of the article hints at this, but it doesn’t explicitly state that the advisor and the custodial account should not be at the same firm. Yes, you could miss out on private equity or hedge fund opportunities. But most investors, unless they are exceedingly wealthy, can’t afford to park large chunks of money in illiquid private equity or hedge fund investments for an extended period.
Joseph From Minnesota
I appreciate the author’s work, yet the advice is so very simple and obvious! I regret that this very obvious and highly superficial advice needs to be given at all. What is really sad is that supposedly sophisticated investors often do not ask these questions.
Regarding Madoff, I believe that a basic principle of a ‘con’ applied: Let the investor/participant believe that some ‘little degree of cheating’ is going on, but to his or her benefit. Then that individual will ignore the obvious to attempt to achieve a benefit from the ‘little cheating.’ Thus, the seemingly sophisticated investors ignored the obvious to accept what they assumed was minor cheating to their benefit (in Madoff’s case, front running was assumed and thus the basic Ponzi scheme was hidden).
Allan From California