We all want high returns on our money right?
Of course, we do. But how do we measure what is “high” and what is high enough to be worth our time, effort, and risk?
Traders and investors seem to get excited about all sorts of levels of profit. Some are excited when a short term CD (certificate of deposit) is paying more than 2%.
Others aren’t impressed unless they see 20% returns in an investment account.
Still, others are seeking the ultra-high returns in the hundreds of percent annualized.
As you can see, there is an enormous range of what is considered to be “high” returns.
If you don’t have a way to provide context about risk, then you can’t appropriately select an amount of return you should expect or seek.
So, how do we put returns into context to explain how both 2% and 200% are considered high?
The answer is to change your denominator.
You see, both 2% and 200% are talking about return on capital. But capital is the total amount of money required, not necessarily the total amount of money put at risk.
In a government-insured CD, 2% is essentially risk-free.
However, an opportunity with 200% upside is not going to share that characteristic. In fact, it’s not uncommon to see such strategies drawdown 100% or more at times. That makes it impossible to actually experience with all of your capital because at some point you wouldn’t have any money left to continue.
(A drawdown is how much your account drops in value at any point before it recovers and begins to be profitable again).
Similarly, a 20% annualized return doesn’t come with essentially zero risk. You will normally see an account like this fluctuate quite a bit. For example, we’ll assume that 20% annualized return has lost 25% at some point.
Now we have some context about risk, so we can apply our #1 Metric That Shows If High Returns Are Worth The Risk.
The metric we use is called ARET/MDD (annualized return divided by maximum drawdown).
Example 1 has 2% return with 0% drawdown. That is infinite ARET/MDD, although low overall return.
Example 2 has 200% return with 100% maximum drawdown. That is an ARET/MDD of 2.0. Since you don’t want to go broke, you must select an amount of money you are willing to lose along the way. We call this Drawdown Allowance. If you allocate 3% of your net worth toward this drawdown, then you can aim for 6% annual return overall. Do you feel the excitement starting to fade away on that big headline number of TWO HUNDRED PERCENT?
Example 3 has 20% annual return with 25% maximum drawdown. That is an ARET/MDD of just 0.80. If you apply the same Drawdown Allowance in Example 2, then you are looking at just 2.4% annual return based on your risk tolerance.
Here’s a question to help you take away value from this.
Did you, like many others, focus on which level of returns sounded more “reasonable”? Did you think 2% is low but very reasonable and 20% is good and maybe still reasonable… and that 200% is just too high to be reasonable?
If so, then you could have focused on the 20% annualized return that simply wasn’t worth the risk. Instead, you could go after the 200% return strategy at 1/0th the size and experience far less drawdown. Not only that, you would be using far less capital (1/10th the capital), giving you more cash to put into that zero-risk 2% income.
The takeaway: Always put returns in context by looking at the drawdowns… then resize them to fit your Drawdown Allowance so that you have a better idea of the portfolio level returns rather than the headline return on capital.