In a managed account, risk is more important than Return. No, this is not some masochistic investment idea. It is true.
A complete understanding of risk and how it affects your investment is crucial before participating in a managed product. Unfortunately, too many investors have a blind fixation on return and wind up getting exposed to a much higher risk level than they're comfortable with.
Before discussing some guidelines about risk in managed money, it is important to define "risk" itself.
Definition of Risk
"Risk" is probably one of the most abstract words in the history of man. When it comes to investments, it is no less strange.
Unfortunately, there's no perfect way to definite risk and mainstream academia does a poor job of using the standard deviation of historical returns to define it.
There's really no perfect equation to calculate risk, but there are some guidelines that are used by some in the money management industry that can shed some light on the subject.
Risk Guidelines – Look at the Drawdowns
We can get pretty sophisticated when it comes to using mathematical expressions to assess risk in managed forex, but we won't do it. When we perform our due diligence on a professional trader applying for our FastTrack trader recruitment program, we pay close attention to his drawdowns. Drawdown, is the amount (in %) the equity in an account has fallen from a peak to a trough (bottom). The maximum drawdown is the largest historical drawdown the account has ever experienced.
Drawdowns are an inseparable part of managing money, even though the traditional investment community adopts a "hush-hush" approach when it comes to providing this figure in their marketing materials.
In the world of professional money management, a manager is considered very good if he's able to keep his maximum drawdown or risk at 1/2 or less of his annualized return. Most portfolio managers, commodity trading advisors (CTA's) and hedge fund managers do not achieve this; yet investors continue to allocate billions of dollars into these programs!
The Drawdown < 1/2 Annualized Return = Good Money Manager equation can be better understood with a numerical example. Let's say that a manager is generating 50% returns a year. Is that "good?"
It's impossible to tell, without knowing how much "risk" he is taking to achieve those returns. If the manager's maximum historical drawdown is 25%, that is half of his 50% annualized return. That is considered very good in our industry and, as mentioned earlier, most established investment managers don't achieve this, meaning that their maximum drawdowns are higher than 50% of their yearly returns. In the world of stock and bond mutual funds, the figures are even more dire, as the great majority of managers draw down more than what they produce in return in 1 year! Yes, it's a sad fact!.
Despite the fact that most managers don't clear the DD<1/2 Annual Return hurdle, there are talented traders out there that are doing it (even though no one knows what the future holds). It is a possibility, although a difficult feat to achieve indefinitely.
Expecting 3 to 5% a month in net returns is not unrealistic. Nevertheless, investors need to be willing to withstand drawdowns of at least 20% at some point in the future to achieve it (even if they're lucky and never wind up experiencing it). In other words, they need to understand the realities of risk when it comes to their managed account.