Wednesday, February 5, 2014

Risk Adjusted Returns Come Early In Bull Markets

While most are familiar with the concepts of risk and return, very often investors overlook the risk component when looking at stock returns.  For instance, when considering equity returns, it would be very easy to make the statement that the S&P 500 at 1750 is up 400 points (or roughly 30%) from its March 2011 levels of 1300.  While true, it is a statement that doesn't consider risk.  The best proxy for equity risk is the CBOE Equity Volatility Index (VIX), which captures the implied volatility of the stocks comprising the S&P 500.  

Below is a chart showing the S&P 500 relative to the VIX.  While the S&P 500 was indeed up 30% from March 2011, at the same time, equity volatility has risen from 15% to 20% recently.  So, while returns were +30%, risk was +33%, resulting in no net increase in the risk-adjusted performance of the S&P 500 in almost three years.  

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From July 2011 to October 2011, the risk adjusted S&P 500 fell roughly 70%.  Off the October 2011 lows, the risk adjusted S&P 500 rose 300% into the spring of 2012.  From that point to today, risk adjusted performance is actually down by 3-5%.  

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This simple calculation of risk adjusted performance helps illuminate when the equity market is adequately compensating an investor or taking equity risk, or not.  Off the lows in March 2009, the risk adjusted S&P 500 rose almost 500% into the spring of 2011, reminding us that the majority of the gains in a bull market com in the first two years off the lows. 

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