An alternative to ROR that will change the way clients think about investing

By Roccy Defrancesco

The Wealth Preservation Institute


When clients consider different investment options, the first thing they look at is the historical rate of return. The second most important thing clients look at is the amount of risk associated with the investment.

When I say investments, I’m talking about stocks, mutual funds (including index funds), REITs, bonds, etc.

Almost every client piece I’ve ever read about investing in the stock market focuses on the easy-to-understand statistic rate of return (ROR).

Risk is not something that is easy to quantify, so you don’t see much statistical data on it; and it’s not something many advisors know how to talk about in a quantifiable way with clients. Everyone knows the stock market is risky. It tanked in 2000–2002 (-46 percent) and in an even bigger way from the highs of 2007 to the lows of 2009 (-59 percent).

Is ROR the best way to discuss and pick investments? I don’t think so.

Let me ask you this: Which one of the following is the best investment for your clients?
  • Investment one, with a net return of 9 percent

  • Investment two, with a net return of 9 percent

  • Investment three, with a net return of 9 percent
They all had the same return, so how do you choose?

What if the following were the risks the investor would have to take on to achieve the net 9 percent rate of return?
  • Investment one risks: -4 percent

  • Investment two risks: -10 percent

  • Investment three risks: -20 percent
Now, which one would the client prefer? Which would you prefer? Investment one, with a 9 percent rate of return that only risks 4 percent of the client’s money.

But I didn’t tell you what each investment was. Should that matter? Would it matter to your clients?

It’s time to change the discussion from ROR to return-per-unit-of-drawdown Risk (RUDR. RUDR is inherently broken into two parts:
    1) determining drawdown risk and
    2) determining the expected return.
Why should clients take more risk to achieve similar investment results? They shouldn’t. One reason they do is because they don’t understand RUDR. Why? Because the advisors pitching investments don’t understand or talk about it.

Defining maximum “drawdown” risk

Maximum drawdown risk for a period of time is defined as the percentage loss from a peak to a trough after the peak. The following chart of SPY (SPDR S&P 500 ETF) from 2005 to present shows the maximum drawdown of this period (55.2 percent) as well as that in 2011 (18.6 percent).

In English please. OK, so, from 2005 to 2012, the S&P generated an average rate of return of 4.9 percent. To generate that ROR, the client had to risk a 55 percent loss over that time frame.

If you said to your clients that you could get them an average rate of return of 4.9 percent and that they only had to risk 55 percent of their money to do so, would they take that investment? No way!

In 2011, the S&P was up 2.11 percent. However, the maximum drawdown risk was 18.6 percent. So again, I ask you, if you explained the risk in 2011, would your clients have risked 18.6 percent of their money to generate a 2.11 percent rate of return? No way!

Now, we don’t know what next year’s RUDR is going to be, just like we don’t know how the market in general, or any individual stocks or bonds will do. But we do have very specific data going back 50+ years. When you analyze that data, what becomes clear is that it can be very risky to invest in the stock market. Take a look at the MDDR percentages of the S&P 500 going back to 2000.

The million-dollar question

Would your clients rather be in the S&P 500 with an average MDDR of approximately -19 percent (2000–2012) or investments that has beaten the S&P 500 with a low MDDR? To ask the question is to answer it. With research, you can find low MDDR funds that have average returns that exceed those of the S&P 500.

Conclusion

Once you understand the idea of RUDR, you'll be able to have a completely different kind of conversation with your clients that won't revolve solely around ROR, but will also include a meaningful discussion about MDDR. Doing so will set you apart from your competitors and will allow you to pick up millions of dollars more in assets under management each year.