Portfolio Risks Explained

RoboPPA™ describes your portfolio’s and your benchmark’s return performance over your selected analysis period and its measured risk. Those risks are Volatility, 5% Value at Risk, and Expected Shortfall and they are calculated from your monthly returns. In general, the more extreme those values are the more risk there is in your portfolio.

One important fact to remember is that large risk exposures do not mean that your portfolio will have good or bad returns in a particular analysis period. If the market is working efficiently, you should expect that the riskier portfolios will have larger returns in the long run; the shorter run is a different matter due to chance. An exception to this is whether you or your manager have superior information and processing ability to the overall market. If true, you can expect superior returns with what others think is a high-risk portfolio; and RoboPPA™ can identify that superior performance and low risk.

In this blog, we define the risk measures in simple language and the risk values you could expect from market benchmark portfolios. We then describe what the risk measures translate to in terms of returns and the probabilities of attaining those returns.

Risk Variables Defined

Volatility is defined as the standard deviation of the portfolio’s monthly returns, where standard deviation is a measure of the spread of the returns around the average month’s return, of the analysis period. Larger volatility generally means that the interval in which your portfolio return will potentially fall is larger on both the upside and downside. Volatility is also called the Total Risk of the portfolio. Volatility is also applied to a portfolio’s active return in which case it is called Active Risk that measures the risk of deviating from the benchmark’s return.

A Confidence Interval (CI) for monthly return is obtained by adding and subtracting standard deviations from the average return. For example, a representative stock benchmark portfolio had an average return of 1.3%/month and a volatility of 4.4%/month. Its 2-standard deviation confidence interval is CI = 1.3+2(4.4) = 10.1%/month to 1.3-2(4.4) = -7.5%/month. If the monthly return is normally distributed, that confidence interval is interpreted as the bounds return would fall inside of approximately 95% of the months. The CI seems incredibly large, but it is a reasonable representation of the equity market’s monthly risk.

5% Value at Risk (5%VaR) is a so-called tail risk or downside risk measure. For example, an estimate of the tail risk on the S&P500 is 5%VaR = -8%/month, which means that the portfolio has a 5% probability of returning less than -8% in any month.

Expected Shortfall is also a tail risk or downside risk measure that measures the return expected if the portfolio return is less than 0% in a month. For example, an estimate of the tail risk on the S&P500 is Expected Shortfall = -4.6%/month, which means that you expect the S&P500 to return -4.6%/month if a month’s return is negative. This is useful if you forecast a down market with a large probability that causes you to revise the portfolio.

RoboPPA™ calculates these risk measures for your portfolio and your selected benchmarks to aid in your portfolio’s construction.

An Example of Outperformance

Because the software calculates the risks for your portfolio and your benchmark, it is able to assess the value-added by portfolio management .Generally, large portfolio risks should be accompanied by large portfolio returns. Good management produces a quality balance of analysis period returns and risks, compared to your benchmark.

The following are the results for an actual self-managed portfolio valued at $883,000 on Dec. 31, 2018. The portfolio had a $4,900 contribution on Jan. 15, 2019 and a $38,000 withdrawal on Jan. 31, 2020 and the analysis period ended on Dec. 31, 2020. The owner selected a benchmark of 80% TSX Composite ETF and 20% S&P500 ETF (unhedged).

The preceding RoboPPA™ chart shows the portfolio’s risks were volatility = 4.1%/month, 5%VaR = -5.5%/month, and expected shortfall = -3.5%/month compared to 5.1%, -6.1%, and -5.1%, respectively for the benchmark. This active portfolio was clearly less risky than the benchmark because each portfolio risk measure was preferred relative to those of the benchmark. The important question is, did the portfolio have less return commensurate with the lower risks?

From RoboPPA™, the actual portfolio returns were rate of return (IRR) = 18.12%/year and average return = 1.48%/month, respectively, compared to 15.3% and 1.32%, after ETF expenses and transfers for the benchmark.

Based on the calculated risks and returns, the manager appears to have information not reflected in market prices, for this time period. However, the analysis period is only 24 months and it may be argued that the manager was lucky and not informed. Nonetheless, the ability to produce substantially more return with substantially less risk is remarkable and suggests that the manager was informed.

A significant advantage of RoboPPA™ is that the required inputs for its performance analysis can be saved in its template and updated monthly. This can be done entirely on the user’s computer and never stored on the software’s servers. The software maintains the benchmark databases thereby reducing the user’s work. Finally, the software allows analyses over any selected period contained in the data template’s horizon, providing it exceeds eight months.

Caveats

The analysis and the results in this document are not to be interpreted as representative of real markets and asset classes and are not warranted to be correct or complete. The example is based upon our opinion and interpretation of the data and results, which may be incomplete or incorrect. RoboPPA™ or the data suppliers are not responsible for any damages or losses arising from use of this blog. Details on the performance calculations are available on www.RoboPPA.com.