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Technical Risk Ratios

Most investors would be aware that there is a risk vs. reward component to every investment. To use a simple example, Guaranteed Investment Certificates (GICs) have low (principal) risk since the capital invested is guaranteed but correspondingly, the reward is low as one can tell from the rates offered in the current market environment. On the other hand, stocks have a high risk since the invested capital could theoretically go down to zero if the company goes bankrupt. Nonetheless, this risk is offset by the higher return achievable through a combination of dividends and capital gains. Hence, investors use technical risk ratios to assess the risk-adjusted return of an investment. The following is a brief overview of each of them.

R-Squared

R-squared measures the degree of correlation between the movement of the security/fund in relation to the index. R-squared values range from 0 to 100: an R-squared of 100 indicates that all movements of a security can be explained by movements in the index, while an R-squared value of 70 or less signifies that the security does not behave like the index. An R-squared value between 85 and 100 indicates the security’s movements are similar to its benchmark index. A high R-squared value makes beta (see below) more useful, whereas a low R-squared value renders the beta irrelevant.

Beta

Beta refers to the reaction (volatility) of the stock or fund to changes in market conditions. A beta of 1 indicates that the price movement of the stock will follow the markets. In other words, if the index rises by 5%, then the security with a beta of 1 will also show a similar increase. A beta of less than 1 (e.g. utility stocks) means that the stock is less volatile than the market, while a security with a beta greater 1 will show higher volatility (e.g. technology stocks) than the market.

Alpha

Alpha is a coefficient which measures risk-adjusted performance and compares it to a benchmark index by considering the risk due to a specific security rather than the overall market. E.g. The excess return achieved by a mutual fund with respect to the return of the benchmark index is its alpha; an alpha of +1.0 means that the fund has outperformed its benchmark index by 1% and an alpha of -1.0 means that the fund has underperformed its benchmark index by 1%.

Standard Deviation

This metric measures the fluctuation of a dataset from the mean; the more variant the dataset, the higher the deviation from the mean. E.g. The annual return of a high-volatility technology stock may have a higher standard deviation than a Dividend Achievers List stock. Standard Deviation is an important tool for the computation of Sharpe Ratio.

Sharpe Ratio

Sharpe Ratio is defined as the degree of risk taken by a portfolio, in relation to the risk-free rate offered by a Treasury Bill, to achieve the desired performance (return). It is a useful metric to deduce if a portfolio return is due to investment skills (using low risk) or excess risk. The higher the Sharpe Ratio, the better the risk-adjusted performance. A negative Sharpe Ratio indicates that the Treasury Bill would have achieved a better return than the security in question!

Do you use any (or all) of these ratios to determine your stock or fund’s risk-adjusted performance? How have your numbers turned out? Is the added risk translating to better returns?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.







6 Comments, Comment or Ping

  1. 1. Brandon

    One correction and an addition.
    1) The Sharpe ratio is actually the total excess return of an investment over the risk free rate (as stated) in relation to (i.e. divided by) the total risk of the security (i.e. its standard deviation). It isn’t used to much in a positive/negative sense – its more common use is to look at two portfolios and determine which makes a more “efficient” use of risk. If one manager gets an additional 1-2% return, but takes on 10% more risk (std. dev.) then they might not be making an efficient use of risk.
    2) One that might be worth adding is the information ratio. This is a managers active return (portfolio return – benchmark return) divided by active risk (standard deviation of tracking errors relative to the benchmark). Similar to the Sharpe ratio, this is a measure of the efficient use of *active* risk (rather than *total* risk).

    I was thinking about starting up a website to discuss investment topics such as this… do you think there is room (or interest!) in the blogosphere for this type of information?

  2. Thanks for this, Clark.
    Great info!

  3. 3. Henry

    Brandon: You are correct.

    However, there is no point to use the Sharpe Ratio or Information Ratio if the portfolio manager does not outperform the benchmark.

  4. 4. Goldberg

    I have an M.Sc in Finance and have learned about these and many more in great details and have used them in my papers and exams…

    They are nice in academic terms and somewhat for the financial industry but its all garbage in reality.

    For an investor who manages his own money, risk is not volatility, its the possibility of losing all or most of its capital.

    Every other risks are distraction to him. So Pepsi held over a long period, paying/raising its dividend is not very risky. A mining stock is very risky. That’s all.

    Most people who read this blog have a regular job, only manage their own money – not other people. This article was useless to them.

    And possibly dangerous since its a distration from their real objective which should be capital preservation – not beating an index to have a positive alpha )and justify its fund manager salary/bonus).

    For 98% of the readers of this forum, the key to their success will be to KEEP IT SIMPLE. These ratios complicate things for them and belong in a fund manger magazine. Not here.

  5. 5. Laura Johnson

    This article references the Sharpe Ratio. This financial benchmarch is misleading in several resepects.
    i)It assumes risk can be measured by mean and standard deviation. This is only the case for normally distributed returns. Most equity funds are not, and display skew and kurtosis in their returns
    ii) It penalizes upside volatility. Most investors are only concerned with downside volatility (upside volatility is good!)
    iii) Negative Sharpe Ratios are misleading (if a Sharpe Ratio is negative, then increasing volatility increases the Sharpe Ratio)

    Now, other benchmarks are available which do not have these drawbacks. For example,
    i) The Sortino Ratio only penalizes downside risk.
    ii) The Omega Ratio takes into account the entire returns distribution (and does not assume normality). There’s a spreadsheet to calculate the Omega Ratio here: http://optimizeyourportfolio.blogspot.com/2011/06/calculating-omega-ratio-with-excel.html

  6. The Omega Ratio spreadsheet I mentioned in my earlier comment has moved to http://investexcel.net/219/calculate-the-omega-ratio-with-excel/

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