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Time to focus on risk-adjusted returns

Investors are not always getting the full story when they read investment performance reports, which often fail to report on the impact of volatility and capital losses.

With equity markets more volatile in recent months, actuarial consultant Milliman says investors should be paying more attention to risk-adjusted returns.

Milliman’s head of fund advisory, Michael Armitage, says investment performance tables often present returns by adding total annual returns and dividing by the number of years to produce an average annual return.

Armitage says: “This approach fails to show the impact of volatility and capital losses and how they erode the power of compound interest.”

He says two funds can have the same average annual return but different compound returns because of the impact of negative years. A fund that underperforms four out of five years can produce a higher compound return if it does a better job of managing market downturns.

“Sacrificing some upside participation in order to manage negative environments delivers the better outcome in the long run. Lower volatility and lower drawdowns allow the power of compound interest to work its magic on the final result,” Armitage says.

“As markets turn into negative territory, a portfolio that retains most of its account balance is best poised to benefit from the market rebound. By avoiding the worst of the market downturn and volatility, investors have less need to capture the maximum return when markets are strong.”

Diversification through owning a broad range of assets, including stocks, bonds and alternative investments provides some protection. But the behaviour of many assets becomes correlated during severe stressed periods, such as the GFC, providing fewer benefits than investors expect.

Milliman’s view is that investors should look beyond one-year returns or long-term average returns that don’t take compounding into account. Managing volatility and drawdown are the keys to meeting long-term goals.