How Much Risk are you willing to take? 

Assessing Risk-Adjusted Returns in Investments

Do you get distracted by ‘shiny new objects’? We are inundated with pitches to invest in the sexy new thing that will promise you amazing returns. ‘Projected returns’ are only one aspect. In general, in order to attain greater returns, some form of risk needs to be taken. But do you really know how much risk you are taking with your money?

For relatively ‘safe’ investments, money deposited in a bank savings account will generate a smaller return (as of this writing, 2-4%), US treasury bonds are yielding 4-5%, whereas greater target returns are in ‘riskier’ assets, such as the stock market with its historical 9% annual return.

You can put your money into a single hot stock tip, or cryptocurrency and hope that you generate 100%, 500%, or greater returns. However, with those greater potential returns, there are fluctuations and possibilities of losing some or all of your money.

Amazon stock has had an amazing 10-year average annual return of 23.67%, however, has had multiple drawdowns of greater than 50%, with the highest being 94.4%. Bitcoin has had an astounding average annual return of 230% from 2011 to 2021, but also has regular drawdowns, with the greatest being 93%.

It seems like a no-brainer after the fact, but can you honestly stomach watching the value of your investments go down that much?

Investing involves making informed decisions that maximize returns while managing risk. One crucial concept that helps investors evaluate investment opportunities is risk-adjusted returns. By considering the risk involved in an investment, investors can make more informed choices and compare various assets effectively.

Risk-Adjusted Returns: An Overview

Risk-adjusted returns refer to the measure of profitability gained from an investment, considering the level of risk taken to achieve those returns. In simpler terms, risk-adjusted returns help investors answer the question, “Is the potential reward worth the risk?”

Because they are more liquid (can easily buy and sell), stocks and cryptocurrency are more susceptible to market volatility than real estate.

A well-diversified portfolio can help mitigate risks associated with individual allocations by reducing volatility. By spreading investments across different assets, sectors, industries, and geographic regions, investors can reduce exposure to individual-specific risks and enhance risk-adjusted returns.

When comparing risk-adjusted returns in real estate vs. stocks, commodities, and cryptocurrency, several key differences stand out:

Risk Profiles: Real estate investments tend to offer more stability due to their physical nature and the potential for consistent rental income. Stocks, commodities, and cryptocurrency, on the other hand, involve market-related risks and can experience significant volatility.

Liquidity and Transaction Costs: Stocks, commodities, and cryptocurrency offer greater liquidity, allowing investors to adjust their positions quickly. In contrast, real estate investments may require more time and incur higher transaction costs when buying or selling properties.

Diversification Opportunities: Stocks and commodities provide greater diversification options, with the ability to invest in a wide range of industries and companies.

Risk-adjusted Returns in Real Estate

Investors with a higher risk appetite may be more comfortable with the inherent fluctuations in stock, commodities, and cryptocurrency prices, while those seeking stability may prefer real estate’s relatively predictable returns. 

Real estate investments are known for their potential to generate stable income and appreciate value over time. However, evaluating risk-adjusted returns in real estate involves considering several factors as previously outlined in our 4 legs of Real Estate Series. 

Sharpe Ratio 

One widely used measure for assessing risk-adjusted returns is the Sharpe Ratio, which measures the excess return generated by an investment relative to its volatility or risk. It factors in the returns, the risk-free rate of return (on a ‘safe’ asset such as US Treasuries), and the standard deviation (the amount of volatility).   

The greater the Sharpe ratio value, the more attractive the risk-adjusted return, and the better the investment when compared with other investment portfolios.

When comparing different asset classes, the key factors are the returns and the level of volatility, with greater returns increasing the Sharpe ratio and greater volatility reducing it.

Over any long-term period, commercial multifamily has the best Sharpe ratio of any other real estate asset class. As seen in the above graph, it also beats the stock and bond markets over a twenty-year period. 

Conclusion

Understanding risk-adjusted returns is crucial for making informed investment decisions. While real estate offers stability and potential appreciation, stocks, commodities and other volatile investments such as cryptocurrency provide diversification and liquidity. Investors must carefully assess the risk profiles, liquidity needs, and personal preferences when comparing risk-adjusted returns when making investments. 

Diversifying and including real estate in your portfolio can help stabilize it and achieve better returns by decreasing the standard deviation of returns and increasing the Sharpe ratio. 

If you want to talk about how you can build and preserve wealth and generate passive income like the ultra-rich, set up a time to talk with me