The most important mistake amateur investors make is they select investments based only on their past short-term returns while ignoring the volatility of returns.
Investors should select investments which combine high average returns and low volatility.
To examine an investment’s performance, you must analyse the following characteristics:
Average Annual return
Average annual return (AAR) is the percentage historical return of an investment. Typical mutual fund average returns are between 5 and 10%. The annualised return must be calculated across different economic cycles to capture the fund’s performance during both bull and bear markets.
Volatility describes the degree to which an investment’s value moves up and down. This is the investment’s risk. The fund above had a volatility (or annualised standard deviation of returns) of 9.10%. This means that the investor should expect the fund to generate between -9% and +9% during a given year based on historical data.
Tip: Investors should select investments with the highest return possible and the lowest volatility
A strategy suffers a drawdown when it loses money. Maximum drawdown measures the largest single drop from peak to bottom in the investment’s value.
For example, if an investor starts with a $100,000 investment which then becomes $120,000 and then the investment reverts back $60,000 and ends at $80,000, then the maximum drawdown experienced is $60,000 (the biggest drop from $120,000 peak to $60,0000 trough) or -50% ($60,000-$120,000/$120,000).
As an investor you need to ask yourself, realistically how deep a drawdown will you be able to tolerate and not liquidate your portfolio?
Tip: Investors should select investments with the lowest possible maximum drawdown. Investments with Maximum Drawdown between 5% and 20% are considered safe investments.
The Balanced Portfolio (in blue) above experienced a -10% Max Drawdown while the US Stock Market (in orange) -65%.
An investment’s performance should be examined for long historical periods of at least 10 years to confirm how an investment performed during different market environments (Growth and Recession, bull and bear markets).
The historical performance of the Balanced Portfolio above covers 10 years of monthly returns which is adequate. Check the green versus red months showing performance consistency.
Market crashes: Special attention must be given on how the investment performed during market crisis like 2000 dot-com bubble, 2008-2009 crash etc.
Tip: Longer periods of historical performance often guarantee similar future investment performance irrespective of the market environment.
The Sharpe ratio shows how much return you get for every unit of risk (volatility measured by standard deviation) taken.
Tip: Good safe investments generate Sharpe ratios between 1.0 and 2.0
An investment’s net performance must be examined after all costs have been deducted.
- Mutual funds embed their costs into what investors see as their net performance.
- Financial advisors charge a flat fee covering the whole advisory, which is generally based on a percentage of assets under management (AUM). Common values are between 1-2% of AUM.
- Investors in individual securities (stocks, ETFs etc.) pay commissions for trade execution, so when analysing a specific strategy, it is critical to examine the total trading costs. The 2 major variables to check are 1. The frequency of trading and 2. The cost per trade (typically $5-10).
Tip: The higher the cost of an investment, the greater the erosion of an investor’s returns is and hence the more difficult it is to generate profits.