A topic I haven’t covered in a long time (and, based on a comment left by someone yesterday on my Facebook page, some people aren’t familiar with ) is risk adjusted return.
Most amateur investors make the mistake of chasing returns.
In the world of crypto-currencies, this manifests as investing in the hot alt-coin of the moment, investing in cheap coins so you can buy more in case it pops and trying to day trade or swing trade.
Chasing returns is a rookie mistake that eventually turns out to be VERY expensive.
When you focus on performance numbers alone, we are focusing on this number – which is an average return over some period of time.
You may hear a number in the press like Bitcoin went up 303% for the year in 2017 or some alt-coin has doubled in the last week.
The problem with that number is it leaves out risk.
In a crypto portfolio, there are many considerations to think about when choosing what assets to invest in beyond just the return.
These include fees, scams, risk of being hacked …Just to name a few.
But, those are topics for another day. What I want to talk about today is risk.
There are two approaches to risk. One is to ignore it completely and HOPE it doesn’t bite you in the butt. That sounds like a good strategy, doesn’t it?
The second is to manage risk and return as two inter-related pieces of an equation.
This is the way big institutions, foundations, trusts, pension plans, and insurance companies manage their portfolios.
It’s also how we manage a Sane Crypto portfolio.
So let’s start with the basics …
The definition of risk is the standard deviation of return. In other words, how much variability is there in that return?
The line from one price to another is never straight.
How much variability… how much up and down is there, mathematically?The standard deviation. This is how risk is measured.
So let me just give you an example. Imagine I have two tokens … Both have had a return of 35% this month.
But one has had a standard deviation is ±90%.That means that 2/3rds of the time, the return would fall between 125% and -55%!
The other token has the same return but it’s standard deviation is only ±30%. So 2/3rds of the time, the return would fall between 65% and 25%!
All things remaining equal, which do you want to own? The correct answer is B. The token with the 35% return and only 30% standard deviation.
If one job of the investor is to make sure that he or she gets the maximum amount of reward for each unit of risk taken, (which BTW, it is!) then the appropriate way to view performance is to take the two competing variables – risk and return – and put them together. This is something called risk adjusted return.
Risk adjusted return looks at how much return did you make for each unit of risk that you took on.
It can be measured several ways but the most common is something called the Sharpe Ratio.
If I look at one portfolio that has returned 70% and another that has returned 50% and all I look at is return percentage, I would think the 70% portfolio was better.
But think again. If the 70% portfolio has a risk level of ±90% and the 50% portfolio has a risk level of ±20%, on a risk adjusted basis, the 50% is actually better than 70% because of the consistency of the return.
If you would like to know more about the value of consistency, in absolute dollars, see a really, really old post I wrote called the Fred Fiasco. The example refers to equities, not crypto, but the principle still holds.
Crypto sycophants who get more listeners and views by continually refilling your cup with Kool-Aid, seldom talk to you about risk. What a wet blanket!
But it’s all fun and games until somebody gets hurt!
The only way to measure two investments or two portfolios side by side is to compare them on a risk adjusted basis.
Otherwise, you are comparing apples to oranges.
And, the irony is, over time, by chasing higher returns, you will actually, over time, make less.
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