Letters to the Editor
To the Editors:
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
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