NEW YORK — Arriving at portfolio optimization through calculating mean returns and standard deviation is simply not enough — especially when analyzing the risk-return profiles of alternative investments — argues Warun Kumar, founder and president of Sigma Advisors, LLC, a new consulting firm in New York.
Mr. Kumar explained that standard deviation, the measure of volatility of an investment, is not thorough enough because it simply tells an investor the average deviation of an investment's return from its mean return. "Standard deviation assumes that the upside and downside of an investment is exactly the same," Mr. Kumar said.
What investors should focus on is kurtosis, he said. Kurtosis examines the pattern of dispersed returns and therefore gives a better indication of how often and by how much an investment has strayed from its mean return. Negative kurtosis indicates low volatility. "When you think about it, in a non-normal distribution, the mean return is the most unlikely of outcomes," said Mr. Kumar. "For example, at a foundations and endowments conference I recently attended, one endowment officer said the mean return of the hedge fund he invests in is 7%, but the fact is the hedge fund has never once returned 7%. It returned 8% some years and 5% or 6% in others."