Pop Quiz! Which of these portfolios had the best performance over the last three years?
A) Portfolio 1 +65.8%
B) Portfolio 2 +56.5%
C) Portfolio 3 +42.5%
D) Not enough information
Easy, right? The answer is obviously Portfolio 1 because it had the highest return.
That’s at least how the vast majority of the investing public and many in the financial press would have answered the question, but it’s incorrect. Investment return is not the same as investment performance.
To properly evaluate investment performance you must consider risk as well as return. The correct answer to my quiz is D, because I did not provide any risk metrics.
The portfolio with the lowest return, (Portfolio 3) had the best performance. Why? Because Portfolio 3 has the lowest risk.
Risk comes in many different varieties. There is business risk, financial risk, liquidity risk, political risk, currency risk, and so on and so forth.
There is no single quantitative measure of risk that can summarize all of the risks an investor takes, but one metric that investors often use to gauge the riskiness of a portfolio is beta. Beta is a measure of volatility. A portfolio with a beta of 1.5 should be expected to rise by 15% if the market is up 10% and to fall by 15% when the market is down by 10%. Conversely a portfolio with a beta of 0.50 should be expected to rise by 5% when the market is up 10% and to fall by 5% when the market is down by 10%.
Okay then. Let me lift the veil on the three portfolios in my quiz. Portfolio 1 is the Fidelity NASDAQ Composite ETF, Portfolio 2 is the S&P 500 (the market), and Portfolio 3 is the SPDR Utilities ETF.
The SPDR Utilities ETF has a beta of .53 and a return of 42.5%. The S&P 500 (the market in our measure of beta) has by definition a beta of 1. The Nasdaq ETF has a beta of 1.1.
Based on the .53 beta of the SDPR Utilities fund and the 56.5% return of the S&P 500, the SPDR Utilities ETF should be up about 30%. The actual return of SPDR Utilities is 42.5% – a difference of 12.5%.
Now let’s look at the Nasdaq ETF, the portfolio with the highest return in the bunch. The Nasdaq fund has a beta of 1.1, putting its expected return at about 62% (56.5%*1.1). The Actual return of the NASDAQ ETF is 67.3%–a difference of 5.2%.
So although the NASDAQ ETF delivered a greater return, it did so by taking more risk. The SPDR Utilities fund with a return that is 12.5% more than would have been expected based on its beta is the best performing fund in the group.
Why did I drag you through a full-on-nerd explanation of beta and risk?
I want to help arm you with the intelligence necessary to avoid the emotionally charged investment decisions that wreak havoc on many investors’ portfolios. Decisions I see too many investors making today.
If you have a conservative portfolio that has lagged the market in recent years, you may be feeling tempted to make up for lost time. Tempted to buy the stocks that have performed the best recently. Before you make any rash decisions, be sure you have both the ability and the willingness to take on the additional risk that will be required to make such a move. Remember, risk is a two way street. On the way up, more risk sounds like an exceptional idea, but on the way down, higher risk strategies often cause great emotional hardship. Hardship that pushes some to bail out near the bottom, only to get back in after much of the losses have been recovered.
The best path to personal investment prosperity is to first take only as much risk as you are willing and able to take and then, and only then, to worry about return.