LOW-RISK-INVESTING

Income Portfolio Design Tool      Saturday, July 12, 2014
Low Risk. High Returns. The Holy Grail of Investing

Low Risk Investments Discovery Tool





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The essence of intelligent investing is maximizing returns while minimizing risk. Low risk, high return investments are the holy grail of investing. Total Return, Volatility and Correlation are invaluable metrics when constructing a well diversified investment portfolio- volatility for quantifying the risk of individual securities (stocks, mutual funds, ETFs etc.) and correlation for measuring the degree to which the value of stocks and funds move together. 

A common measure of an asset’s risk is its volatility.  It has been observed that assets with low correlation tend to lower the overall volatility of an investment portfolio. Harry Markowitz won the Nobel for his pioneering work in this area. However, there are few easily accessible tools for calculating volatility and correlation available to the individual investor, especially for arbitrary periods.

The above free tool calculates the return, volatility and correlation values for a basket of stocks, mutual funds or ETFs (exchange traded funds). A good use of the calculator would be to study the risk/return attributes of stocks and funds during various economic conditions (eg. bull markets vs bear markets) so that you can design an investment portfolio that suits your temperament and financial goals. It will be a very useful tool in your quest for high return, low risk investments. Please see more detailed discussions of return, volatility and correlation below.
 

   
Annual Return: This is the compounded annual growth rate (CAGR) of the security for the period calculated using monthly  closing prices adjusted for stock splits and dividend distributions. The return includes stock  price appreciation and dividends.  A common mistake when assessing the annual return of mutual funds is using the simple average return.

The problem with this method is illustrated with a simple example of a 2-year period when a fund is down by 50% the first year and up 50% the following year. Using simple average return, the investor is even at the end of 2 years ( -50% plus +50% which is 0% divided by 2 = 0%). In reality, the investor is actually down 25%. $10,000 invested is worth $5000 at the end of the first year, which then appreciates 50% in the second year and is now $7500. In this example, the compounded annual return is -13.4% which is a more accurate representation of the actual return.  You can use the above calculator to find the compounded annual return of stocks, mutual funds or ETFs for any period. 

Volatility: A common measure of risk associated with a security is its volatility represented by the standard deviation. In the world of stock investing, one takes on risk with the hope of being rewarded for it in the long run. In other words, you are generally rewarded with a premium in returns (relative to a safe investment such as US government note) for taking on additional risk. This is called the risk premium. If not for the potential premium in returns, why invest in anything but the safest instruments? Generally, the higher the expected return, the higher the volatility.

The volatility calculated by this site is the annualized standard deviation of monthly returns calculated using the adjusted closing prices which includes dividend distributions. So, what does the standard deviation number tell us? It tells us that there is a good chance (66.7% to be precise) that the annual return of the asset will be plus or minus one standard deviation of the average return. For example, if the average return is 15% and the standard deviation is 10%, then the expectation on the return is between 5% and 25% (which is 15% +/- 10%).  Another way to think of volatility is as the "uncertainty in returns" associated with a security.  A US government bond fund will be less volatile than a tech stock.  All else being equal, the lower the volatility, the better.  In the above example, Stock A is clearly more volatile than Stock B.

Correlation:  Correlation is a measure of how two securities move in relation to each other.  When assembling a basket of investment securities, ideally you want them to be minimally correlated to one another. You do not want all your securities moving in tandem.  However, this is easily said than done. In the real world, markets and asset classes are becoming increasingly correlated. However, by using the above calculator you will be able to identify stocks, mutual funds and ETFs that are not highly correlated.

The correlation value is a number between -1 and +1. A +1 indicates a perfect positive correlation, meaning the securities move together in tandem. A -1 indicates a perfect negative correlation, meaning when one zigs the other one zags an equal amount. A zero correlation means the investments move independent of each other. Ideally, you want assets with low or negative correlations in your portfolio. When one or more of your holdings depreciate in value, you would want other holdings to pick up the slack. In the Performance Details table generated by the calculator, the Average Correlation is the average of all correlation values calculated for that particular security.

It is worth noting that correlation between two securities can and do vary over different periods. Two securities with perfect correlation during one period may have negative correlation during another. It is important to study correlation behaviors during various economic periods such as bull markets and bear markets. During the economic melt-down of late 2008 to early 2009 it can be seen that the correlation among securities were very high. Even securities that had minimal historic correlation lost their values together.

Historical Data:   All calculations are performed using Yahoo Finance adjusted monthly closing price data.  Please see the following link for a detailed explanation of: Yahoo Finance Historical Data.

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