When considering the value of a specific asset, appraisers typically look to one point in time at which to anchor their value conclusion. Typically, that point in time is today. What's the asset worth today? When one applies for a loan on her home, the lender wants to know the collateral value of the home today.
Investors want to know value at two points in time: 1) today ("Point A"), and 2) at a future point in time ("Point B"). Estimating today's value is tricky enough, but now try to estimate what something will be worth in the future. Lots of assumptions are involved, and seldom, if ever, does the future work out exactly as predicted. Yet, most would conclude that if Point B is greater than Point A, the investment enjoyed a positive return.
But we in the finance world are hesitant to draw that conclusion until we have evaluated the journey from A to B. The volatility of the trip from A to B qualifies the success of the trip. In other words, the bumpiness of the trip matters.
Let's assume two investments travel from the exact same Point A (say, $1,000) to the exact same Point B (say, $1,200) over the exact same time period. It is very possible that one of these investments provides a positive risk-adjusted return to its investor, while the other investment provides a negative, risk-adjusted return to its investor. The key words are "risk-adjusted", which essentially means bumpiness of the investment trip. The positive return investment might be a bond fund, while the negative return investment might be a venture capital fund. They have the same absolute dollar returns, but one investment is positive, and one investment is negative, once adjusted for risk.
Each year, I sit in several investment committee meetings or situations of similar context and listen to the members laud the returns of particular investments, for which the risk adjusted returns stink like a polecat. Bottom line: bumpiness matters!
Posted on Sun, July 8, 2012
by Tim Moffit filed under