Jamarlin Martin: The Concept of Risk-Adjusted Returns in Markets and Life

Jamarlin Martin: The Concept of Risk-Adjusted Returns in Markets and Life


Images: unsplash/ pexels/ mmg

I have a friend who is fanatical about crypto. He is also very knowledgeable about the emerging asset class and has made good money investing in it. As I see it, the defective area with his thinking is that he sees percentage returns as the slam-dunk case for the asset.

Because the speculative risk asset increases 500 percent in five years, that means it is a good investment, among other factors. This approach is too heavily weighted on the return side but doesn’t factor in the mother of all investment decisions: how much risk are you taking to get the return? 

In finance, many professionals and insiders look at the unit of return per unit of risk. These folks are usually managing a lot of money but this concept is just as important for the smaller retail investor. Take Apple for example, which has a compelling profit, cash flow, and brand story. We can prove these metrics scientifically. Hypothetically, let’s say Apple goes up 6X or 500 percent in five years. By comparison, crypto-asset A does the same thing over the same five years with nerve-wracking volatility, sleepless nights, and multiple 80-percent drawdowns. In this hypothetical case, these assets give the investor the same return on a percentage basis but the Apple investors are far better off. They are getting the same return with less volatility and risks than the highly volatile and speculative crypto assets. 

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Bitcoin could be one of this year’s worst-performing assets judging by its returns for volatility. It rose to almost $64,000 in mid-April and is now about half of that.

The Sharpe ratio helps investors understand the return of an investment compared to its risk. The risk-free rate of return is the return on an investment with zero risk, meaning the return investors could expect for taking no risk. The yield for a U.S. Treasury bond, for example, could be used as the risk-free rate. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.

Image: Goldman Sachs

Another way to look at this is to consider the risk of young Black men being killed after going after a financial return in the business of music. Chicago rappers face risk over affiliations with hardcore gangbanging and threats on YouTube and Instagram against other gang members. Let’s say the market opportunity to up the ante and make more threats means a $1 million paycheck from record labels or selling direct. 

The riskier you are and the more the fans follow you, the more controversial and hardcore you look. Is the $1 million payday a good deal for the rapper, who makes 20 diss tracks on YouTube to help get his $1 million? The rapper is an investor. It all looks good when we just look at the positive side — the check. 

When we factor in the risks, the statistical and financial scientist will say the rapper is at high risk of being killed or paralyzed in an attack by one of his diss victims based on the historical patterns and data — the science. The scientist will say the rapper is taking way too many risks for that $1 million as there is an 80-percent chance of him getting murdered. The rapper could respond and say, “After I got my $1 million, I am still alive. You are wrong! Because I didn’t get shot over the last three years, this means my investment was smart, savvy.”

The three-year time horizon may not be sufficient to capture the real risks for what has been said and done. Someone could always come back after and murder the rapper. Most reasonable people who value life would agree that maybe $1 million of investment return is not worth the 80-percent probability of getting murdered within five years. Sometimes we need time for bubbly markets to return to tried-and-true investment science. 

My main point is it’s better to be aware of how many units of risk we are taking for each unit of return. Just because a crypto has gone up over 500 percent in five years doesn’t mean you are being compensated for the high risks you are taking. You may have to accept a lower return for a lower risk profile. Alternatively, you may be able to find another asset that can possibly achieve a similar return, but with a significantly lower volatility and risk profile. Like Apple, outperforming while also having a lower risk profile than the broader stock market and a significantly lower risk profile than the highly speculative crypto market.

Always be aware of the risks you are taking to achieve your return and whether you are being sufficiently compensated for the risks. The Chicago rapper who took the $1 million may be murdered in the fourth year. He looked smart in the third year but was murdered in the fourth year. The bubblehead only looks at the P in a profit and loss statement, only looks at the positives and leaves out the potential negatives. The bubblehead doesn’t consider investment returns based on the investment return per unit of risk. What looks like a good deal based on prior parabolic returns in a massive speculative bubble, is probably not.  

I explained some of the risk factors of the potential collapse in crypto and a broader speculative asset bubble on my podcast on April 11, 2021. 

Listen to GHOGH with Jamarlin Martin | Episode 74: Jamarlin Martin Jamarlin returns for a new season of the GHOGH podcast to discuss Bitcoin, bubbles, and Biden. He talks about the risk factors for Bitcoin as an investment asset including origin risk, speculative market structure, regulatory, and environment. Are broader financial markets in a massive speculative bubble?

What I say is not sexy with the popular crowd because while everyone is partying, I bring risk factors into the picture by looking at the past parabolic bubble returns. The brokers, exchanges, bubble pumpers and marketing charlatans will keep things one-sided, focused on just the return opportunity in favor of the bubble. Thinking about risks first, before profit, will keep you in the game longer — in life and markets.