The Value of Risk-Adjusted Returns

Many investors, amateur and professionals alike, treat investing as if it's a contest.

In this approach, the winner is the investor who is beating the market. The rest are losers. But if you're a long-term investor, focusing on the market as a benchmark to beat is a mistake.

That's because successful investors aren't focused on the horse race. Just as important to them as returns is avoiding big losses. It's those big losses, after all, that can shrink your capital base and put your long-term goals out of reach.

Major losses are even more concerning if you're near, or in, retirement. That's because you have less time to recoup losses—and if you're taking distributions from your account at the same time you're absorbing significant market damage, you can be in real trouble.

All of this is why long-term investors should focus not on pure return, but on what's known as risk-adjusted return. Risk-adjusted return measures your investments' performance against the level of risk you've accepted to get that performance.

In a simple example, a low-risk investment that earns you 10% has a better risk-adjusted return than the risky one that earns you 10%. To put this in context, imagine that in 2010, you invested all your savings in small-cap stocks. Smart move—you earned a return of 27%! (Isn't 20/20 hindsight fun?) The problem is, if you happened to make that investment in 2011, you would have lost 4.2%.

The larger the loss, the more capital, and thus compounding power, is destroyed in your portfolio. For this reason, losses are difficult to recover: Making up a 10% loss, for instance, requires an 11% gain.

Portfolios that are built to achieve risk-adjusted returns help to address this problem. They feature thorough diversification across a range of stocks, bonds and, in some cases, additional asset classes.

Spreading your bets around in this way means you aren't going to match the best-performing asset class in any given year. But it also means that you won't lose as much as the asset class that's bringing up the rear. Over the long term, a properly constructed portfolio will help you avoid wipeout-type losses, and its risk-adjusted returns will help you to achieve the goals that are the most important to you.

Don't hesitate to contact us if you'd like to learn more about how a focus on risk-adjusted returns can help you make your vision for the future a reality.

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