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Stocks & Commodities V. 2:2 (76-79): Analyzing Risk/Reward Tradeoffs by Fred S.
Gehm
Analyzing Risk/Reward Tradeoffs

by Fred S. Gehm
These days, more and more potential traders are avoiding the day-to-day problems of commodity trading
by committing their funds to professional money managers. For many, perhaps most, this is a reasonable
decision, although unfortunately it does not solve all of their trading problems. Deciding to use a money
manager only replaces the many difficult and important problems of trading with a few very difficult and
very important problems.
The most obvious and most important problem is that of selecting a money manager in the first place.
With several thousand individuals offering managed accounts of one kind or another, how can the "best"
money manager be selected?
Selecting a Money Manager

It's been my experience that most individuals ask the wrong questions when attempting this selection.
They look for a manager with the highest potential returns, that is, the one who might possibly make the
most money. A somewhat more reasonable approach is to select a money manager who is likely to make
the highest return, a subtle but all-important difference.
One way to do this is to calculate the average returns of each of a group of money managers and then
select the manager with the highest average return. This approach has a number of virtues, but
unfortunately, it also has a number of problems. The most obvious is that a money manager's average
return does not necessarily describe very well the actual return the investor might expect to receive.
Figure #1 shows the average returns of a certain money manager. Although the manager's average return
per quarter is 10%, that manager has never yet made an actual return per quarter of 10%.
The extent to which the average return is not a meaningful measure is generally considered to be the risk
a trader must accept. The more widespread a manager's returns, the less meaningful the average return
and the more risk there is in trading with that manager. (The standard deviation of returns is one of
several methods of measuring this type of risk. See Figure 2.)
It is clear that both risk and reward should be considered in selecting a money manager. It's also clear that
tradeoffs or compromises must somehow be made, but what is generally less than clear is how to make
the necessary tradeoffs.
The first step in solving the risk/reward problem is to analyze the available alternatives. Figure 3 is a
chart showing all possible solutions to the problem. The vertical axis is the return expected from
managed accounts. The horizontal axis is the standard deviation of the expected return. In Figure 3 the
only actual combinations of risk and return possible are those on and to the right of line a-a'.
Not all possibilities are equally desirable, of course. Manager W has the same return but a lower risk than
Manager Z. Manager Y has a higher return for the same risk as Manager Z. Manager X has both a higher
return and a lower risk. Notice that the most desirable managers are on line a-a'. It is often possible to
find another manager with a higher return for the same risk, one with lower risk for the same return, or
one with both higher return and lower risk.
Technically, line a-a' is known as the market frontier. When individual managers are involved, locating
Article Text Copyright (c) Technical Analysis Inc. 1

Stocks & Commodities V. 2:2 (76-79): Analyzing Risk/Reward Tradeoffs by Fred S. Gehm
FIGURE 1:
FIGURE 2
Copyright (c) Technical Analysis Inc.

FIGURE 3
FIGURE 4
the market frontier is not particularly difficult and it can easily be done by hand. However, when a
portfolio of money managers is involved, the market frontier is more difficult to locate. (It can still be
located, but more complex algorithms are needed.)
A portfolio of money managers consists of one or more money managers, and there are some virtues in
using more than one manager, if the speculator can afford to do so. As long as the managers all trade
profitably on average, and as long as the managers' profits are not perfectly and positively correlated with
one another, a portfolio can produce a smoother and faster account growth than any individual manager
(see Figure 4).
The result is that the market frontier is pushed up and to the left (see Figure 5), and the frontier is closed.
It is no longer necessary to search for a money manager with the desired risk and reward characteristics,
and the speculator can turn his or her attention to creating an investment portfolio.
Selecting an Investment Portfolio

"Selecting" is really a more accurate word for the process that takes place. Modern portfolio theory
provides a means of selecting the single investment portfolio that best expresses an individual's taste for
risk and return from the large, perhaps infinite number of portfolios on the market frontier. To do so, the
individual must be able to define his or her feelings about risk and reward clearly and unambiguously,
which demands that the individual spend some time thinking about those feelings. For most individuals,
this is difficult to do. Possibly, a well designed questionnaire or a skilled interviewer could help.
To be useful in portfolio selection, an individual's feelings about risk and reward must be expressed as
either a risk/reward indifference map or as a utility curve. A utility curve is a graphic representation of an
individual's feelings about money, the satisfaction, pleasure or utility that an individual gets from having
money.
Clearly, the utility of money varies from individual to individual, and even changes from time to time for
a given individual. Consider a starving man . If you gave him a single dollar, he would no doubt value it a
great deal. If you gave him another dollar, he would value that a great deal also, but perhaps just a little
bit less than the first one. However, if you continued to give him dollars until he had a million of them,
he would almost certainly not value the millionth as much as he had the first.
In this example, notice that while the man's total utility for money increases without limit, the marginal
utility for money, that is the utility for the next dollar, decreases to a limit of zero. Almost all individuals
have decreasing marginal utility for money. (But not quite all. Misers and financial theorists have
constant marginal utility for money. And gamblers, especially high rollers have increasing marginal
utility for money. See Figure 6.)
The Risk/Return Indifference Map

Utility theory clarifies an individual's utility preferences. For example, you might be interested in an
investment that produced a return of 20% a year with a standard deviation of 4%, but uninterested in an
investment that produced a return of 13% a year with a standard deviation of 50%.
Clearly, there would be still other investments that you would be indifferent to. For example, you might
be indifferent as to whether you kept an investment with a return of 12% a year and a standard deviation
of 3%, or traded it for an investment with a return of 13% a year and a standard deviation of 5%. You
might also be indifferent between investments where the first has a return of 12% and a standard

FIGURE 5
FIGURE 6
deviation of 3%, and the second has a return of 121/2% and a standard deviation of 41/4%. For any given
individual there is an infinite number of such tradeoffs to which he is indifferent. These tradeoffs
constitute an indifference curve (see Figure 7).
By definition, any point on a risk/return indifference curve represents an investment or speculation that
gives the same satisfaction as any other. A single indifference curve, therefore, is of limited use. It does
not account for the obvious fact that some combinations of risk and reward are more desirable than others.
To account for this, a risk/return indifference map is needed. This is a collection of indifference curves
with each curve representing a different level of satisfaction (See Figure 8). Notice that as we move up
the map, we move to curves representing progressively more desirable investments.
Note also that risk/return indifference maps and market frontier maps are drawn in the same space that is,
they have the same vertical and horizontal axes. A risk/return indifference map shows how an individual
feels about risk and return. A market frontier map shows what combinations of risk and return are
possible. By combining the two maps, the single best portfolio for any individual can be discovered or
created.
As noted above, higher indifference curves represent higher levels of satisfaction. And the most desirable
portfolios lie on the market frontier. Clearly, the single most desirable portfolio is located at the point
where the market frontier touches the highest indifference curve (see Figure 9).
The Value of Modern Portfolio Theory

Modern portfolio theory is one of several techniques that can be used to select either money managers or
portfolios of money managers. Almost all of the techniques used are identical in the goals set and the
assumptions made. Most of these techniques assume that the future will be essentially identical to the
past and therefore judge money managers on their past performance. Managers are ranked in some
manner according to their past returns, and those with the highest rankings selected.
Of the techniques in this class, and there are many, Modern Portfolio Theory is clearly the best. Modern
Portfolio Theory consistently produces optimal results, which is something no other technique can do
except in special cases. For example, Sharpe's well known ratio produces optimal results when the
client's utility curve is quadratic (but only then.)
Optimization, however, can easily be overstressed. Indeed, this seems to be an occupational hazard of
those who use such techniques. There is no such thing as optimal commodity trading. There are only
techniques that produce optimal results in certain situations.
Essentially, an optimization technique produces the best possible answer to a certain well defined
question. However, there are always other questions that might be asked. There are always other risks to
be considered than the variability of trading profits, and other techniques than Modern Portfolio Theory
must be used to manage the risks involved.
Another problem with Modern Portfolio Theory is that it demands rationality, and many people simply
are not rational when it comes to trading. Modern Portfolio Theory does not allow utility curves to kink
or double back, for example, which some individuals' utility curves will do.
But clearly an irrational individual should not do his own trading. These individuals, more than for
anyone else, if they would trade in the commodity market, should use a money manager.

FIGURE 7
FIGURE 8
FIGURE 9
Fred S. Gehm is the president of F. Gehm & Associates. His firm consults on topics concerning trading
advisor selection, portfolio strategy, price behavior and other money management topics. He is the
author of Commodity Market Money Management and numerous articles. Direct correspondence to:
2727 Midtown, Suite 37, Palo Alto, CA 94303.
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Stocks & Commodities V. 2:2 (76-79): Analyzing Risk/Reward Tradeoffs by Fred S.

Analyzing Risk/Reward Tradeoffs

Selecting a Money Manager

Article Text Copyright (c) Technical Analysis Inc. 1

Copyright (c) Technical Analysis Inc.

Selecting an Investment Portfolio

The Risk/Return Indifference Map

Article Text Copyright (c) Technical Analysis Inc. 2

The Value of Modern Portfolio Theory

Article Text Copyright (c) Technical Analysis Inc. 3

Figures Copyright (c) Technical Analysis Inc. 4

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