Risk vs. Reward

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Much attention is focused on the performance of stock recommendations, but what about risk?  Which firms offer recommendations with the least risk?  To find out, we analyzed the performance of stock recommendations made by stock research firms tracked by Investars, a New York based performance measurement specialist, for the period from from June 30, 2009 through June 30, 2012.  Investars provided performance history for 98 research firms, both investment bank-affiliated and independent, used in this analysis.

The table below presents the performance and risk of the buy recommendations for the firms in the Investars universe with the lowest risk characteristics over the past three years.  Excluded from the analysis were research firms which covered fewer than 200 stocks during the period.

Research Firm Return of Buy Recommendations Volatility of Buy Recommendations Maximum Loss
TheStreet.com Ratings 41.0% 15.4% -18.0%
GMI Ratings 81.3% 18.1% -22.5%
Rochdale Research 73.2% 18.5% -20.9%
S&P 500 Average 51.3% 20.9% -23.2%
Investars’ Average 74.3% 23.6% -27.9%

The performance measures the cumulative return that would be achieved over the last three years if the buy recommendations of the research provider had been followed during the  period.  We included two risk metrics: the volatility, or standard deviation, of the buy recommendations and the maximum loss, or drawdown, an investor would have experienced following the recommendations.

Standard deviation is a measure of the variability of the returns generated by the buy recommendations.  Using the S&P 500 index as an example, the standard deviation of returns for the last three years was 20.9%, which means that about two-thirds of the time returns were the average return (which was 51% for the latest 3 years) plus or minus 20.9%.  In other words, two-thirds of the time, cumulative three year performance for the S&P 500 was between 30% and 82%.  The larger the standard deviation, the higher is the associated risk.

Maximum drawdowns provide another filter to assess the riskiness of the research recommendations.  The maximum drawdown is a measure of the largest percentage loss the recommended stocks would have experienced during the 3 year time horizon.   For example, using the S&P 500 index returns, an investor would have lost over one-fifth of their portfolio value (23.2%) if he or she were unfortunate enough to buy the index at its highest point and then sell the index at its lowest level during the last three years.

The firms with the lowest volatility of returns for the three year period ending June were three independent research firms: The Street.com Ratings, GMI Ratings and Rochdale Research.  The standard deviations of the three year buy recommendations were 15.4%, 18.1% and 18.5% respectively.  In other words, two-thirds of the time, The Street.com Ratings’s performance during the period was between 25.5% and 56.4%; GMI Ratings’ between 63% and 99.4%; and Rochdale Research’s between 54.7% and 91.6%.

In contrast, the standard deviation for the S&P 500 was 20.9% and the average standard deviation for the firms tracked by Investars was even higher: 23.6%.

The maximum loss experienced by the lowest risk firms was similarly outstanding.  The maximum loss for The Street.com Ratings had a maximum drawdown of -18% during the period, GMI Ratings -22.5% and Rochdale Research -20.9%.  In contrast, the maximum drawdown for the S&P 500 was -23.2% and the average maximum loss for the Investars’ universe was -27.9%.

When we look at performance relative to risk, we generally expect to see lower performance as a result of lower risk.  This is the case for The Street.com Ratings, with the three-year performance of 41% lagging the returns of both the S&P 500 and the Investars’ universe.  Rochdale Research’s performance of 73.2% bested the S&P 500 but not the average return for the firms covered by Investars.  GMI Ratings’ performance of 81.3% proved the exception, with performance exceeding both the S&P 500 and the Investars’ universe.

In the chart above, we can see the risk/return profiles of the least risky providers relative to the Investars’ universe.  The average return and risk for the firms tracked by Investars are marked by the blue gridlines in the chart.  Both The Street.com Ratings and Rochdale Research provide lower risk and lower return than the average for the Investors’ universe while GMI Ratings provides higher returns along with lower risk.

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