Hi Guys,
I too liked and used Risk Grades. I will miss their portfolio risk assessment. I will particularly miss their portfolio stress test option. Too bad that all good things must end, just like the shuttering of the popular FundAlarm service. We miss that too, but we will get over it.
Now, in no way do I want to demean the usefulness of Fund Grades; it yields terrific portfolio metrics relative to risk measurement, control, and management. However, understand that the website used very common analytical tools developed under the general rubric of Modern Portfolio Theory.
The sites primary advantages were that it assembled inclusive global performance databases, formulated a risk measurement that was scaled to permit easy comprehension, allowed stress testing of a portfolio against classical historical meltdowns, and was user friendly in a manner that encouraged candidate inputs to check overall impact of the provisional input against the existing portfolio. Indeed, Risk Grades was a robust and useful tool.
Be aware that Risk Grades was not a gift from God; its grandfathers were really the academics from the 1950s onward like Harry Markowitz, Bill Sharpe and Gene Fama.
Although somewhat disguised by its scaled (normalized) scoring, the Risk Grade is nothing more than a portfolio’s overall standard deviation. The normalization is simply accomplished by dividing the particular investment’s standard deviation (volatility) by a generic equity market’s historic standard deviation. The last time I reviewed the Risk Grade documentation, a S&P 500 Index-like normalization factor of like 20 was in play based on a market history survey.
It is amusing to recall how one distinguished and departed member of the old FundAlarm Board relentlessly badmouthed volatility as a total measure of risk, yet he strongly endorsed the Risk Grade methodology, which is totally based on recorded standard deviation metrics. The Emperor had no clothes. He was correct in recognizing that risk is a multi-dimensional concept. Risk ultimately must be assessed by quantifying the likelihood and scope of losing money.
Users of Risk Grades should realize that their calculation of standard deviation weights the daily data inputs using a specified decay function. That means that the most recent data is more heavily weighted when computing averages while the most distant data inputs barely influence the scoring. There is nothing wrong with that technique; just be aware that it is a part of their procedures.
Also, embedded within the Risk Grades analyses is the assumption of a Normal (Bell Curve) returns distribution. That too is a simplifying approximation to the actual data sets which too often deliver some wild perturbations.
As Nassim Nicholas Taleb accurately reported in his “The Black Swan” book, the Bell curve does not handle wild market fluctuations (fat tails) very well. The Normal distribution underpredicts the frequency of such market disruptions quite dramatically, so the methodology underestimates risk. It does little to recognize even the existence of Black Swans.
So we will soon lose an imperfect but useful friend. What to do?
Remember Mom’s advice that there are many ways to skin a cat.
Here is the address to the Business Finance Online website that is specifically directed to its two-asset portfolio calculator:
http://www.zenwealth.com/BusinessFinanceOnline/RR/PortfolioCalculator.htmlThe Business Finance website offers many other user friendly resources including the equations that are integrated into the calculator that I linked. For now, let’s focus on the two-asset calculator. Please access it.
Note that it is simplicity itself. The only inputs required are two estimated returns, two volatility (standard deviations) projections, and a forecasted correlation coefficient between the two investment options being explored.
The output is the expected returns and the resultant volatility for the composite two candidate holdings as a function of the percentages of the first holding. The table is computed in 10 % increments of the first holding.
Here is the work-around procedure that I promised.
Identify your current portfolio as “Stock 1”. Identify your candidate addition to the portfolio as “Stock 2”. Use either the historical returns and standard deviations as the needed inputs, or some modifications based on your current market perceptions.
I typically use macroeconomic factors to modify the inputs. Currently I’m forecasting somewhat muted future returns with somewhat higher volatility estimates. The needed inputs should reflect your perspectives and preferences. They’re all guesstimates anyway.
The spectrum of valid Correlation Coefficient (CC) estimates scale between -1 and +1 limits. A plus one means that the two investments move in perfect lockstep; a minus one means that the two investments are totally out of sync. A zero input value indicates that the movements of one investment relative to the other is completely random. Correlation coefficients are dynamic and change over time. Check history; estimates are entirely acceptable.
From a practical viewpoint, it is impossible to find investments that ever approach the minus One CC limiting level. Valuations at the -0.5 level are rare. At times, -0.2 CCs are generated between two disparate holdings (gold against equities, for example). Values at the 0.97 echelon translates into very small diversification benefits. CCs above 0.98 are really closet Indexing products regardless of their claims otherwise.
Other illustrations include equity/bond CCs that vary between 0.2 and 0.5, US equity/foreign equity CCs that range between 0.5 and 0,8, and cash/equity CCs that often hover around 0.0. The cash/equity CC identifies the diversification benefits of holding a cash or near-cash (short term corporate bond fund) position within your portfolio.
I suggest you parametrically try several Correlation Coefficient inputs when using the referenced calculator to scope its impact of your proposed portfolio modification. Experimentation and exploration is a key to both scientific and investment success.
I recognize that the referenced calculator is no substitute for the Risk Grade closure. But it is an investment tool that is a partial replacement for that respected resource with one addition attraction. The tool will give you an understanding of how portfolio changes impact total portfolio performance in an incremental way. I consider it a valuable educational and self-coaching tool.
Please give the calculator a try. The costs are minimal; the rewards are potentially high.
Best Regards.
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Skeeter