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!

Ka-ching!

Future benefits, for which a number of financial metrics serve as a proxy (e.g., free cash flow), are only meaningful when evaluated within the context of risk. In other words, a dollar of return from one type of investment may be worth more or less than a dollar of return from a different class of investment. For example, a dollar of return from a manufactured housing community investment is certainly worth more than a dollar of return from a technology start-up. Risk matters!

Even within asset classes, the required return differs based on the quality and characteristics of the future benefits stream. Often these benefits are reflective of underlying asset quality. A large, modern manufactured housing community that targets seniors in a Sunbelt state location requires a measurably lower required rate of return than small, single-wide “trailer park” that targets low-income residents in rural Indiana. Why? The explanation is found in the expected size, growth and certainty of the Sunbelt location property’s cash flows in comparison to those of the rural Indiana property.

Before you judge a return, be sure to evaluate it within the context of its embedded risk.