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Alpha Theory Blog - News and Insights

« August 2009 | Main | October 2009 »

2 posts from September 2009

September 23, 2009

Institutional Investor Magazine article: A Plea to Put Down the Mental Calculator

I recently wrote an article for Institutional Investor magazine (www.iimagazine.com) called "Capturing the Benefits of Risk-Adjusted Return." It was a plea to put down the mental calculator. You can read the article here.

Here is an excerpt from the article:

Hedge funds throw away half of their potential returns by not explicitly calculating risk-adjusted return. After working for a fund and having numerous conversations with hedge and mutual fund managers over the past decade, it is obvious that an overwhelming majority of funds’ mistakes come from poor estimation of risk-reward. 

In fact, most funds have not explicitly defined an upside price target, downside risk target and conviction level for each investment in their portfolio. This is because most fund managers trust that they can manage the portfolio in their head. They analyze and discuss the upside, downside and conviction level for every investment so they assume these factors’ influence is carefully measured into every decision. But I would posit that there is a distinct difference between factoring in upside, downside and conviction level through mental calculation and measuring it with risk-adjusted return. 

Why would you trust your mental calculator for such an important decision? Could you imagine a bungee jumper that knows the height of a bridge, tension of the bungee cord and weight of the jumper but just estimates the correct length of the bungee cord? Absolutely not. For every jump, a calculation is performed to make sure that easily avoidable risk is eliminated.  Investors all too often skip the “bungee cord” calculation of risk-adjusted return and end up assuming undue risk. 

September 03, 2009

What is your investment’s Risk-Adjusted Return? The Alpha Theory Calculator will tell you.

Alpha Theory is exposing its pioneering Risk-Adjusted Return Calculator to the public at www.AlphaTheory.com/Calculator. This calculator lays the groundwork for every important portfolio decision an investment firm will make and calculates a first-ever Estimated Risk-Adjusted Return. Try it out by entering any stock, seeing its Estimated Risk-Adjusted Return, and then customizing your own Risk-Adjusted Return. Enjoy the calculator and please share it with others who may find it worthwhile.

 

The Risk-Adjusted Return calculation is the most effective way to measure investment quality. All research can be distilled down into the elements of potential profit, downside risk, and probability of each coming true. This holistic framework results in a quantitative measure that can be used to make the critical portfolio decisions of whether or not to make an investment, how to size the position, and when to trade. The use of Risk-Adjusted Return in portfolio construction reduces risk by decreasing position size when an asset has greater downside and increasing return by maximizing the portfolio’s overall Risk-Adjusted Return.

 

The Alpha Theory Risk-Adjusted Return (RAR) Calculator begins by giving you an Estimated Risk-Adjusted Return using market metrics. Enter one of your investments and see if the Estimated Risk-Adjusted Return is positive or negative. This Estimated RAR starts by deriving an Upside and Downside Price Target using an average 52-week high and low and 1-year annualized volatility implied high and low. Then, the Calculator derives probabilities by determining the Option-Market Implied Probability of the Upside and Downside targets being achieved. The Calculator then averages the Option Probabilities with Normal Distribution Implied Probabilities of Upside and Downside. The Alpha Theory Estimated RAR should be a part of every investment process.

 

The next step is to customize with your own research. Alpha Theory allows you to override the estimates with your own assumptions to truly appreciate the stock’s impact on your portfolio. Risk-Adjusted Return is the foundation of every investment decision and is imperative in ensuring that an asset’s position size is in-line with your fundamental research.