How To Evaluate Mutual Fund Returns Like a Pro
I admit it, at one point in my early investing years I fell into one of the most common traps that an investor can make. I looked only at an investments return with little regard for how those returns were generated. Perhaps it was greed or maybe it was just a lack of really understanding the investment decision process. In all likelihood, it was a cocktail of both.
There are formulas and calculations which assign a number as an assessment of risk to a security (investment), but I am not going to cover that stuff here.
Instead of discussing how those numbers are calculated, let’s review why they are important.
All investment returns should be measured against the amount of risk you are taking. If you are looking at returns without understanding the amount of risk you are taking to get those returns, you are making a costly mistake. This is a mistake that in all probabilities will have you swimming in the deep end of the pool without you knowing it.
Imagine if you gave me $10,000 to invest for one year with discretion to invest the money anyway I saw fit. Then, I return to you in one year and inform you that I doubled your money for a 100% return. I think most of us would agree that we would be pretty happy with that type of return over a one year period. So, you ask me, “How did you do that?” I say, “Well Mr. Client I went to Las Vegas and went to the roulette table. I took half the people’s money I had to invest and bet on black and put the other half of people’s money on red. Fortunately for you, black came in and I doubled your money.
I now have to deliver the bad news to the people who had red and lost everything”
This is an outrageous example with an important point. There are many ways to measure risk, but here are 5 common terms to be familiar with and are useful when comparing mutual funds, Sharpe ratio, alpha, beta, r-squared and standard deviation.
Where do I find these numbers?
Most companies who offer mutual funds will have this information. A good 3rd party source is Morningstar.
How do I use these numbers?
Again, how these numbers are calculated are complex and beyond the scope of this article, but we don’t need to know how to calculate them to use them to our advantage.
Simply, pick any one of these risk measuring tools. A lower number means lesser risk. So, if you were comparing mutual funds for example, you could compare both funds returns and say both funds standard deviation. If all things were equal and fund A had a similar return as fund B, but with a lower risk (standard deviation), fund A would have a better risk adjusted return.
In its simplest terms, you are taking less risk for the same return.
There are formulas and calculations which assign a number as an assessment of risk to a security (investment), but I am not going to cover that stuff here.
Instead of discussing how those numbers are calculated, let’s review why they are important.
All investment returns should be measured against the amount of risk you are taking. If you are looking at returns without understanding the amount of risk you are taking to get those returns, you are making a costly mistake. This is a mistake that in all probabilities will have you swimming in the deep end of the pool without you knowing it.
Imagine if you gave me $10,000 to invest for one year with discretion to invest the money anyway I saw fit. Then, I return to you in one year and inform you that I doubled your money for a 100% return. I think most of us would agree that we would be pretty happy with that type of return over a one year period. So, you ask me, “How did you do that?” I say, “Well Mr. Client I went to Las Vegas and went to the roulette table. I took half the people’s money I had to invest and bet on black and put the other half of people’s money on red. Fortunately for you, black came in and I doubled your money.
I now have to deliver the bad news to the people who had red and lost everything”
This is an outrageous example with an important point. There are many ways to measure risk, but here are 5 common terms to be familiar with and are useful when comparing mutual funds, Sharpe ratio, alpha, beta, r-squared and standard deviation.
Where do I find these numbers?
Most companies who offer mutual funds will have this information. A good 3rd party source is Morningstar.
How do I use these numbers?
Again, how these numbers are calculated are complex and beyond the scope of this article, but we don’t need to know how to calculate them to use them to our advantage.
Simply, pick any one of these risk measuring tools. A lower number means lesser risk. So, if you were comparing mutual funds for example, you could compare both funds returns and say both funds standard deviation. If all things were equal and fund A had a similar return as fund B, but with a lower risk (standard deviation), fund A would have a better risk adjusted return.
In its simplest terms, you are taking less risk for the same return.
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