July 2005: Portfolio Basics: Measuring the Risk-Return Tradeoff

PORTFOLIO BASICS: MEASURING THE RISK-RETURN TRADEOFF

Our foremost investment objectives are profits and protection of capital. Our goal as your portfolio managers is to construct portfolios we believe have the potential to achieve above average investment returns using a conservative investment strategy.

Our investment strategy is geared toward providing you with investment returns that exceed the average balanced mutual fund. Our goal is to capture above average returns, but without incurring above average risk.

 

 

The investment world uses several standardized statistical tools that measure risk and return. One of these tools is called a "Sharpe Ratio." It provides a method to evaluate whether or not an investor has been adequately rewarded for the risk he is taking and helps answer the question, "Were my returns worth the risk I was taking to get them?"

 

 

"Our goal is to capture above average returns, but without incurring above average risk."

A Sharpe Ratio measures how much return is received for the amount of risk undertaken (i.e., volatility of monthly returns). This is also referred to as "risk-adjusted return." A Sharpe Ratio can be calculated for an individual mutual fund or a portfolio of mutual funds. This is one of the tools we use to construct and evaluate client portfolios.

Although the calculation itself is arduous, its end result provides an eloquently simple and easy-to-understand tool in the form of a simple number for an individual mutual fund and can be used to compare different mutual funds. The higher the Sharpe Ratio, the better job a mutual fund did in capturing returns relative to the amount of risk incurred.

For example, if Fund A has a Sharpe Ratio of 0.6 and Fund B has a Sharpe Ratio of 1.0, then Fund B (with the higher Sharpe Ratio) did a better job of garnering returns for the amount of risk incurred to get those returns. Therefore, using this standard, Fund B has a better "risk-adjusted return" and would be preferable to Fund A.

We favor funds that have a demonstrated history of superior "risk-adjusted returns." This is one of the factors of consideration in our mutual fund selection process. According to Morningstar©, a provider of mutual fund statistics and ratings, the Sharpe Ratio of our performance benchmark, the Morningstar Moderate Allocation Category (an average of 800+ balanced mutual funds), was 0.67 on June 30, 2005, while the average Sharpe Ratio of Asset Allocation Advisors' fund selections was 1.16. Their historical returns have been excellent (above average returns) for the amount of risk incurred (average risk). Although the past performance of an investment does not necessarily guarantee its future performance, it is our opinion that successful mutual fund managers have the strongest likelihood to continue to be successful.

Our investment selection process also factors in the way different funds work in combination with each other, as much as for the individual attributes of each fund. That’s one of the differences between a "portfolio" and a random bunch of investments.

Portfolio construction and evaluation are two of the ways Asset Allocation Advisors provides our clients with added value. We strive to assemble a combination of individual mutual funds that, when combined as a portfolio, work better than the sum of the individual pieces. That’s the way a portfolio is supposed to work - the components perform better in aggregate than they do separately.

A CLOSING THOUGHT. . .

Good investing is very important. We will always endeavor to protect your capital and provide you with good investment returns. But, investing is not the most important thing we do. Please take a minute to think about this and see if you agree.

As your advisors, we believe our foremost purpose is helping you to live your life comfortably and securely, without needing to worry about money. Of course, that job includes managing your portfolio well, but, even more importantly, it's about dependability. It's about being the people you can call and know we’ll be there for you, and that you will receive the help you need and expect. That is the most important thing we do.

We appreciate you and we are grateful for your business, your friendship, and the ongoing trust and confidence you have placed in us. Thank you.* * *

Greg Schultz & Bruce Grenke
© 2005 Asset Allocation Advisors, Inc.