Constructing Alpha: An Introduction to the Fundamentals of Risk Management
Every investor — from the guy who bets on physical currency by hiding it under his mattress to Ray Dalio — is concerned with risk. Somewhat surprisingly, despite the fact that the vast majority of people are risk averse, very few have any idea what risk actually means or how to measure it… this group includes many, if not most, financial professionals. Ironically, despite retail investors’ often stated aversion to risk, they tend to solely focus on the projected return of an investment seldomly (read never) considering the associated risk-adjusted expected return to determine the investment’s projected excess return to risk borne, or alpha (α), which is the true measure of an investment’s value.
Before we can begin to discuss the calculations of risk, we must first define it. Risk is quite simply the likelihood, or probability, of a negative event occurring weighed by the potential loss associated with such an event. In other words, it is a number that can be computed; and because financial assets are measured in quantifiable units such as dollars, so can the potential downside (unless an investor makes the mistake of investing in a way that incurs unlimited downside risk, which happens quite often). Risk probability is measured as the degree to which something changes; in finance we’re concerned with changes in market values, what is referred to as price volatility — the greater the volatility, or change, in the price of an asset, the riskier it is said to be. The study of computing probabilities is the purview of the mathematical branch statistics and probability theory, and herein lies the reason so few people understand risk.
People tend to dislike math. The human brain evolved to make quick, simple, intuitive judgements to avoid obvious threats such as a venomous snakes and ravenous Pantheras. There was (and for many people to this day still is) little need for mathematics in survival, and if anything, the intellectual resources required to use it would have been a waste of precious energy. Unfortunately in finance, risks are not so obvious and require a considered approach to effectively manage them. In fact, they are extremely complicated and require not only a keen qualitative understanding of an investment’s associated business factors, but also correspondingly complex math to measure them in a meaningful way. It’s worth emphasizing that computations alone are not enough. One of the most significant causes of the 2008 financial crisis was not the arithmetic, but the identification of contributing factors to include in the calculations. It’s arguable that these factors were deliberately omitted to maintain the highly profitable game of musical chairs for as long as possible.
So in lieu of math, when most people consider risk, they revert to an intuitive feeling that most often bears little resemblance to reality. A fairly common example of this phenomenon is the person who is afraid to fly on a commercial plane but has no problem speeding through traffic on a congested highway where the probability of fatality is demonstrably higher. A significantly contributing factor to this misestimation is the fact that people tend to believe that their control over a situation reduces risk, when often times, especially in financial matters, the converse is true. When it comes to investing, people’s desire to reduce perceived risk through direct control is most often expressed through real estate entrepreneurship, despite the fact that they know little to nothing of investing or real estate. A glaringly ironic example of this paradox is the ultra high net worth individuals who rely on a family office for comprehensive investment and financial services except when it comes to real estate where they invariably take the DIY approach. In the fairly rare instances when real estate entrepreneurs begin to consider risk management, they tend to talk in operational heuristics: reduce risk by buying the worst house in the best neighborhood, using qualified professionals, borrowing on decent terms, etc. While these quasi-solutions begin to address issues that each contribute to the probability of a negative outcome, they fall short as a fundamental approach as was made painfully obvious by the colossal losses incurred by real estate investors in 2008 and is likely to occur again in the not-so-distant future.
One of the most elegant approaches to risk analysis is expressed by the Capital Asset Pricing Model (“CAPM”). The CAPM determines the return an investment should pay given its associated market, or systematic, risk. The CAPM calculation accomplishes this task by taking the volatility of an investment’s (e.g. security, business, portfolio of assets, etc.) historical performance as compared to its benchmark [most often the S&P 500 for stocks, in a calculation referred to as beta (β)]. Once the fair rate of return for an investment is calculated by the CAPM, the investment’s value can be easily determined by subtracting the CAPM output, referred to as risk-adjusted expected return, from the average of historical returns of the investment itself; the resulting number from this subtraction is referred to as alpha (α). Alpha (α) is the measure of investment return after accounting for risk, and the pursuit of maximizing it is quest for the Holy Grail of hedge fund managers… I’d go so far as to say that the pursuit of alpha (α) is what defines a hedge fund.
To supplement the CAPM and alpha (α) as a measure of an investment’s value, the Sharpe Ratio focuses solely on the investment’s performance (historical average and volatility as expressed by its standard deviation) relative to risk-free assets (theoretically U.S. Treasuries, although they do possess risk in real terms), not measuring performance relative to a market index. The Sharpe Ratio better measures investment-specific, or idiosyncratic, risk-adjusted performance than its CAPM counterpart. Further differing from the CAPM, the Sharpe Ratio does not output a percentage; theoretically, it can output any real number: a negative Sharpe Ratio indicates that the risk-free asset would perform better than the asset being analyzed; a Sharpe Ratio of one or better is considered good, two or better is very good, and three or better is considered excellent.
As applied to a real estate entrepreneur’s portfolio, assuming the time frame of past performance is sufficiently long (or that such historical performance can be rigorously, theoretically constructed), the CAPM together with the Sharpe Ratio serve as a comprehensive measure of risk-adjusted performance that accounts for both the idiosyncratic (investment-specific) and systematic (macro-economic) variables at play. Why should real estate entrepreneurs bother with such a relatively complex effort? The answer is that residential income affords entrepreneurs the unique opportunity to generate the highest risk-adjusted returns amongst all asset classes. For quality residential real estate entrepreneurs to not measure their risk-adjusted performance is like an Olympic-class sprinter not bothering to time his races. How is it possible that real estate can be such a good investment considering the recent 2008 crash with the current potential for a repeat? While nearly every real estate market participant follows the herd in relying on comparable sales values to determine a “good deal”, the real opportunity lies just beneath the surface: relatively speaking, rental income itself experiences very little volatility:
Constructing investments (i.e. strategic lending, utilizing options, swaps, etc.) predicated on residential income in lieu of simply purchasing property at comparable sales values affords real estate entrepreneurs the ability to generate alpha (α) that even the most sophisticated hedge fund managers would envy. The ability to maximize returns while simultaneously minimizing risk and being able to communicate these performance characteristics not only provides real estate entrepreneurs the ability to substantially increase their profitability, but also positions them to raise unlimited capital from the trillions of dollars held by retail investors starved for low-risk yield.
To learn more about how to analyze and manage risk as a means to better serve the capital markets, email us at [email protected], and take advantage of our risk-adjusted performance calculator so you can evaluate and price your investments like the big banks and confidently pick the best investment every time without having to do the math yourself. The calculator measures both the risk and expected return of investments to let you easily rank them... from stocks to hedge funds to real estate. It also enables you to price your own investment offerings. With over 10 Wall Street investment performance metrics [including Alpha (α), Sharpe Ratio, Omega (Ω) Ratio, Liquidity Premium and many more] for financial professionals and a color-coded rating for non-professionals, this calculator is a must-have for every professional investor.
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