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Risk: Reward Comparisons Between More Volatile and Less Volatile Equity Mutual Fund Portfolios

Figure 1.1

Chart 1.1 Average Percent Gain in Winning Months and Average Percent Loss in Losing Months, Based on Volatility Groups
This chart shows the average gain during months in which the average mutual fund rose in price (winning months) compared to months in which the average mutual fund declined (losing months). Mutual funds are ranked by volatility, the amount of daily and/or longer-term price fluctuation that takes place in that fund, usually compared to the Standard & Poor's 500 Index as a benchmark. Group 9 represents the most volatile group of funds; Group 1 represents the least volatile segment. The period represented by this study was December 1983 to October 2003. The more volatile the group, typically the greater the gain during winning months, the greater the losses during losing months.
Calculations and conclusions presented in this chapter and in other areas where performance data is shown are based, unless otherwise mentioned, on research carried forth at Signalert Corporation, an investment advisory of which the author is sole principal and president. In this particular case, research encompassed mutual fund data going back to 1983, involving, among other processes, simulations of the strategies described for as many as 3,000 different mutual funds, with the number increasing over the years as more mutual funds have been created.

Chart 1.1 shows the relationships between average percentage gains during rising months for mutual funds of various volatility levels (range of price fluctuations) and the average percentage loss during declining market months, 1983 to 2003. For example, the most volatile segment of the mutual fund universe employed in this study (Group 9) gained just less than 3% during months that the average fund in that group advanced, and incurred an average loss of just less than 2% during months that the average fund in that group declined. As a comparison, funds in Group 1, the least volatile segment of this mutual fund universe, advanced by approximately 1.2% on average during rising months for that group and declined by approximately 4/10 of 1% during months that the average fund in that group showed a decline.

Chart 1.1 shows us that, basically, when more volatile mutual funds—and, by implication, portfolios of individual stocks that show above-average volatility—are good, they can be very good, indeed. However, when such portfolios are bad, they can be very bad, indeed. Are the gains worth the risks? That's a logical question that brings us to a second chart.

Gain/Pain Ratios

We have seen that the more aggressive the portfolio, the larger the average gain is likely to be during rising market periods. We have also seen that more aggressive portfolios are likely to lose more during declining market periods. That's logical enough—nothing for nothing. But what are the gain/pain ratios involved?

Well, Chart 1.2 shows that, on a relative basis, more volatile mutual funds involve greater pain to gain, lower profit/loss ratios than less volatile portfolios. For example, Group 9, the most volatile portfolio segment, makes about 3% during winning months for every 2% lost during declining months, a gain/loss ratio of essentially 1.5. Group 1, the least volatile group, has had a gain/loss ratio of approximately 2.7. You make 2.7% per winning month for every percent of assets lost during losing months. The amount of extra gain achieved by more volatile funds is offset by the disproportionate risk assumed in the maintenance of such portfolios.

Figure 1.2

Chart 1.2 Average Gain/Average Loss, by Volatility Group
This chart shows the ratio of the average gain per winning month to the average loss per losing month, by volatility group. For example, Group 9, the highest-volatility group, shows a gain/loss ratio of 1.5. Winning months were, on average, 1.5 times the size of losing months. Group 2, the second-least-volatile group, shows a gain/loss ratio of 2.5. Winning months, on average, were 2.5 times the size of losing months. The period here was 1983 to 2003.

You might notice that relationships between volatility and risk are very constant and linear. The greater the volatility, the lesser the gain/loss ratio, the greater the risk—a relationship frequently lost to investors during periods when speculative interest in high-volatility stocks runs high.

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