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As a financial advisor, mastering the skill of risk management is crucial in delivering exceptional results for your clients. Risk isn’t just a box to tick — it’s the key to navigating market volatility and positioning your clients for long-term success. By understanding each client’s unique goals, time horizon, and risk tolerance, you can create portfolios that don’t just survive the ups and downs but thrive in them.

Effectively managing risk also sets you apart as a trusted advisor who’s always one step ahead, spotting vulnerabilities before they become problems and seizing opportunities that others might overlook. By incorporating risk analysis into your strategy, you can show your clients that you’re not just managing their investments — you’re protecting their future and unlocking their portfolio’s potential.

This article explores the concept of investment risk, how to measure it with a metric called RoMaD, and how you can use this knowledge to create better outcomes for your clients.

Understanding risk

In an investing context, risk can be defined as the potential for an investment’s actual returns to differ from its expected returns. This includes the possibility of losing some or all of the initial investment due to factors such as market volatility, broader economic conditions or company-specific events. While we can never eliminate risk in investing, it can be assessed using metrics such as volatility and maximum drawdown, in tandem with investing strategies that keep your clients’ portfolios aligned with their specific risk tolerance and financial goals.

Using maximum drawdown to measure downside risk

There are many different ways to measure risk, such as alpha, beta, R-squared, standard deviation and the Sharpe ratio just to name a few. In this article however, we will be focusing on a lesser-known metric referred to as return over maximum drawdown (or RoMaD).

Maximum drawdown (MDD) refers to the maximum loss of an asset, from peak to trough. More specifically, it measures the drawdown of a share price from its peak to its trough, and the length of that period.

The formula is as follows:

MDD = (Trough Value − Peak Value) / (Peak value)

For example, let’s say you held a stock with a peak (share price) value of $120 and a trough value of $80 during your chosen measurement period. With the aim of finding the MDD and converting it to a percentage value, you would use the following formula:

(80-120) / 120 x 100 = 33%

Where RoMaD comes in is that by comparing an asset’s return against its maximum drawdown (over the same period), you can get clear, actionable insight into the relative standing of the asset on a risk-adjusted basis.

In the example above, imagining your stock had a return of 7% over your chosen measurement period, you would calculate RoMaD using the following method:

0.07 / 0.33 = 0.212

While RoMaD is not a direct measure of volatility (such as standard deviation), it can act as an indicator. As mentioned above, MDD measures the most significant peak-to-trough decline in an asset’s value, with significant drawdowns tending to occur in highly volatile environments. In this case, the asset will have a lower RoMaD score, signalling higher risk relative to return.

So what’s a good RoMaD score? That depends entirely on your client’s risk tolerance, financial goals and preferred investing strategy. However, you can refer to the chart below as a general guide:

 

It should be noted however that RoMaD should always be used in conjunction with other metrics to perform a robust risk assessment on a client’s portfolio. With RoMaD specifically, it is recommended that you measure the results over a three-year period, as this helps provide a balanced perspective on both performance and risk, capturing medium-term trends while avoiding the pitfalls of overly short or excessively long measurement periods.

Achieving a RoMaD score of 2 is typically seen as the golden standard, as it indicates that for every dollar of maximum drawdown (aka. risk of loss), the investment generates two dollars of return. Essentially, this shows that the investment’s returns are double the level of its worst potential loss. However, the key advantage of RoMaD lies its ability to compare stocks against each other, which we will discuss below.

How RoMaD helps you compare stocks

Let’s say you have a client that has two high-performing stocks in their investment portfolio. Both have delivered similar returns over the past three years, but one has experienced significantly higher drawdowns than the other. When you calculate the RoMaD ratio for each stock, you notice that the stock with a higher RoMaD score has maintained its performance while exposing the broader portfolio to less downside risk, making it a more attractive option from a risk-adjusted perspective.

You can then use this analysis to initiate a conversation with your client about rebalancing the portfolio. In this case, you might recommend reducing exposure to the stock with a lower RoMaD ratio in favour of reinvesting in the higher-scoring asset or other similarly favourable investments.

RoMaD in practice: Rebalancing an SMSF portfolio

Client profile
Type: SMSF investor
Risk profile: Conservative, pre-retirement

Portfolio metrics
Target RoMaD ratio: >2.0
Current RoMaD ratio: 1.8

In this example, the portfolio’s overall RoMaD score of 1.8 indicates that the portfolio’s risk-adjusted returns are falling below the client’s target threshold. This suggests that some investments may be exposing the portfolio to higher-than-acceptable drawdown risks relative to their returns, which could be misaligned with the client’s conservative, pre-retirement risk tolerance.

In this case, you could recommend conducting a review of the portfolio to identify underperforming or overly volatile assets contributing to the lower RoMaD ratio. Rebalancing strategies may include reducing exposure to high-risk stocks with low RoMaD scores and reallocating funds to more stable investments with better risk-adjusted performance, ensuring alignment with the client’s conservative investment goals. Depending on the economic conditions at the time, this may mean increasing the client’s exposure to government bonds, dividend-paying blue chip stocks, index-tracking ETFs or even term deposits and high-yield savings accounts.

Sharesight’s portfolio tracker allows you to automatically calculate portfolio risk with the drawdown risk report. Try it today with a 30-day free trial.


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