VIEWS: 0 PAGES: 2 POSTED ON: 5/18/2012
Risk‐Adjusted Return Calculator Why Should I Use Risk‐Adjusted Return? The Risk‐Adjusted Return calculation is the most effective way to measure investment quality. All research can be distilled down into the elements of potential profit, downside risk, and probability of each coming true. This holistic framework results in a quantitative measure that can be used to make the critical portfolio decisions of whether or not to make an investment, how to size the position, and when to trade. The use of Risk‐Adjusted Return in portfolio construction reduces risk by decreasing position size when an asset has greater downside and increasing return by maximizing the overall portfolio’s Risk‐Adjusted Return. For example, assume you are considering an investment in General Electric (GE). With or without Risk‐Adjusted Return, you will evaluate the potential profit, potential risk, and your conviction level before making an investment. However, without Risk‐Adjusted Return, you rely on your mental calculator to combine all those factors into an investment decision. With Risk‐Adjusted Return you combine the factors into a single actionable package that makes perfect financial sense. If you believe GE has 40% of potential upside and 20% of downside risk and you believe the probability of upside is 70%, then GE has a 22% Risk‐Adjusted Return and would have a positive impact on your portfolio (ie. you would expect to make 40% 7 times out of 10 and lose 20% the other 3). If you get new information that GE’s contract with the US Government has been renewed, you may raise your probability of upside to 80% from 70% and calculate a 28% Risk‐Adjusted Return which tells you how much better the investment is now that they have renewed the contract and allows you to feel confident in increasing your exposure to GE. Of course, your upside, downside, and probabilities are not perfect, but they capture the essence of your research and instinct. The same research and instinct you would rely on without calculating Risk‐Adjusted Return. Acknowledge the uncertainty and stress test your estimates to validate confidence in your assumptions. There is no good reason to forgo calculation of Risk‐Adjusted Return for every investment in your portfolio. Market‐Based Risk‐Adjusted Return 1) Enter a ticker and push “Add Ticker” 2) Alpha Theory lets you compare your own upside and downside estimates against multiple market‐based factors. You can compare how your research measures up against market‐based Option Implied Probabilities as well as Normal Distribution Probabilities. This is a powerful way to validate and assess your research against the prevailing wisdom of the markets. Or, you can forgo the effort of compiling your own research altogether and base your upside and downside estimates on Alpha Theory’s market‐based upside and downsides automatically. a) Market‐Based Price Targets. Upside and Downside prices are calculated using an average of the 52‐ week high and volatility implied upside to calculate an upside price and use 52‐week low and volatility implied downside for downside price. b) Market‐Based Probabilities. Alpha Theory will calculate market‐based Probabilities by averaging Option Market and Normal Distribution‐based probabilities of achieving the Market‐Based Price Targets. The Option‐based probabilities use the strike price closest to the Upside and Downside prices to impute a market implied probability. The Normal Distribution‐based probabilities use the annualized volatility and assume the current price as a mean, to determine the probability of achieving the Upside and Downside. 3) Alpha Theory uses the market‐based price targets and probabilities to calculate a Risk‐Adjusted Return. To learn more, request a trial of Alpha Theory, www.AlphaTheory.com. Risk‐Adjusted Return Calculator Figure 1 – Market‐Based Risk‐Adjusted Return Price Target Probability PT * Prob Upside $26.63 62% $16.51 Downside $4.77 38% $1.81 Risk‐Adj. Value Upside + Downside $18.32 Current Price $13.90 Risk‐Adj. Return Current Price ÷ RAV 32% User‐Based Risk‐Adjusted Return 4) Change the market‐based assumptions to reflect your research by overriding the market‐based upside, downside, and/or probabilities. Click on either the Upside or Downside row and the editable cells will open. 5) Click the “Calculate” button and a Risk‐Adjusted Return based on your research will be calculated. Figure 2 – User‐Based Risk‐Adjusted Return Price Target Probability PT * Prob Upside $22.00 70% $15.40 Downside $5.00 30% $1.50 Risk‐Adj. Value Upside + Downside $16.90 Current Price $13.90 Risk‐Adj. Return Current Price ÷ RAV 22% 6) Verify analysis confidence by stress‐testing assumptions of Upside, Probability and most importantly, Downside. 7) Use Risk‐Adjusted Return to evaluate critical portfolio decisions of whether or not to make an investment, how to size the position, and when to trade. Learn More about Alpha Theory™ and Risk‐Adjusted Return 1) Website. Go to www.AlphaTheory.com 2) Video. View the demos at www.AlphaTheory.com/demo 3) Webinar. Attend an Alpha Theory Webinar at www.alphatheory.com/webinars 4) Blog. Read the Alpha Theory blog at blog.alphatheory.com Begin using Alpha Theory’s Risk‐Adjusted Return‐based System Today 1) Go to www.AlphaTheory.com 2) Click the Try it Now link and request a Trial 3) Receive a username and password from Alpha Theory™ 4) Follow the instructions for the “5 Asset Test” To learn more, request a trial of Alpha Theory, www.AlphaTheory.com.
Pages to are hidden for
"Risk‐Adjusted Return Calculator"Please download to view full document