Often Overlooked but Incredibly Important
Do you understand fully how much risk you are taking with your retirement portfolio? Is the expected return worth it? Today we explore an invaluable tool that smart investors use, to gauge risk vs. return, called the Sharpe Ratio.
What is the Sharpe Ratio?
Investopedia defines the Sharpe Ratio as “the measure for Calculating risk-adjusted return, and this ratio has become the industry standard for such calculations. It was developed by Nobel Laureate William F. Sharpe. The Sharpe Ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.” In general, we can measure the amount of “bank for your buck” or return that an individual security, or asset category, has the potential to deliver in relation to it’s level of risk. The higher the Sharpe Ratio, the better, as this shows higher return per unit of risk.
In the institutional world of pension and endowment investing, the Sharpe Ratio is one of many tools that is used extensively. The goal is to create a portfolio that takes the lowest amount of downside risk to deliver a required return. For individual investors, in my 22+ years of experience, the Sharpe Ratio is rarely if ever considered. Many individuals, of course, instinctively want to reduce risk and generate high returns. It is normally up to savvy advisor to point out the value inherent in utilizing the Sharpe Ratio, among other tools, to create an optimal portfolio. This is where value can significantly be added to the advisor/ client relationship.
For example, for the year ending June 30, 2014, the Sharpe Ratio of high yield European bonds was 6.46, representing an astounding 6.46 units of return versus the risk-free rate. Whereas, for the same period, commodities offered a Sharpe Ratio of only 0.91, providing much less return for the risk. (Source: Redington Risk Adjusted Return: Quarterly Update 2014 Q2)
The Sharpe Ratio can be an extremely useful tool to ensure your portfolio is working on all cylinders.
Don’t Rely Exclusively on the Sharpe Ratio
The temptation is for an investor to design, for example, a stock portfolio, overweight areas with higher Sharpe Ratios, and think that their portfolio is protected against market declines. And this method can be quite effective during a normal market environment. But history tells us that all of that diversification using Sharpe Ratios can be for naught during a severe downturn. For example, during the liquidity crisis of 2007-09, pretty much every stock out there sold off, there was really no place to hide, so just when an investor needed those protection tools to work most was when they failed.
If designing your portfolio using all of these fancy tools does not protect when we need it, then what good are they, you ask?
How about we take this a step further….
How the Sharpe Ratio Can be Used Correctly
To design a great portfolio, with the ideal risk-adjusted return, we model after some of the most successful investors out there. And again I go back to those ultra-successful endowments and pension plans. We can take asset allocation a step further by measuring the Sharpe Ratios of, for example, stocks vs. bonds vs. private equity vs. farmland vs. real estate vs. commodities vs. other, completely unrelated asset categories. This way, if/ when the next severe market downturn occurs, it is more likely that we will have assets that weather the storm much more successfully than stocks-only.
Utilization of Sharpe Ratios across various asset categories, both public and private, combined with correlation measurements, has been shown to more effectively protect a portfolio than when investing in publicly-traded equities only.
A Practical Example
For practical purposes, we are not ever going to be able to have accurate Sharpe Ratio data for every security, asset class, and investment type out there. But if you train yourself to analyze your investments, in terms of the amount of return they can potentially provide vs. the amount of risk, you will stand a greater likelihood of avoiding bad investments.
For example, the MIC, or Mortgage Investment Corp., has been quite a popular investment vehicle over the past number of years. Many investors see the posted yield, reason that “if they invest in mortgages, it must be safe”, and dive right in with a purchase. An investor with a Sharpe Ratio mindset would consider yield, but that would only be within the context of the amount of risk taken, and ask important questions such as:
- What type of mortgages, firsts or seconds?
- How experienced are the managers?
- How is the portfolio diversified geographically?
- What is the current rate environment like? How are rate changes likely to affect my yield?
- What is the current state of the housing market?
Even though the exact Sharpe Ratio for this particular product might not be measured exactly, creating the mindset to consider all important variables can help an investor avoid a lot of potential trouble, and maintain a strong portfolio that only takes the amount of risk necessary to complete the job. This type of thinking eliminates emotion which reduces mistakes also.
I hope you have learned a bit more about thinking like a successful investor, and utilizing tools such as the Sharpe Ratio, to allow yourself the greatest opportunity for investment success.
If you enjoyed today’s article, you are going to love what is in store in the future, as I will be hosting a live online event very soon. This webinar will be filled with ideas on how to create the ideal retirement portfolio, so you can live the life you want, as stress-free as possible. Simply click the orange bar on the upper right of this page marked “click here to see if you qualify” or use the link here. Thanks and happy investing!