We were trying to get excited about investing, we really were, but we got discouraged by how complicated it all is. How do we know where to put our money? How can we choose between two different investment portfolio choices? We were about to give up forever and just start stashing retirement cash in our mattress, but then we came across something wonderful. Something magical. Something that made it oodles easier to choose between investment portfolios.
Its name is the “SFRatio,” which stands for “Roy’s safety-first criterion,” and…it changed our life. Or, at least...it made life a little easier for the few minutes we spent investigating portfolio options.
Anyway, the SFRatio is designed to help us choose between portfolio options by telling us which one is more likely to fall below our minimum threshold for return. Handy, right? And all we have to do is some simple math. The equation is as follows:
SFRatio = (E - M) / σ
“E” is the portfolio’s expected return, “M” is the minimum return we’d be okay with, and “σ” is the standard deviation of the portfolio. So...let’s say our “M” is 6%. We’ve got two portfolio choices. The first one has an expected return of 15% with a standard deviation of 25%, and the second one has an expected return of 12% with a standard deviation of 11%. The first portfolio’s SFratio is .36 and the second one’s is .55.
.55 is higher than .36, so according to Arthur Roy, our ratio’s creator, the second portfolio is the better choice. It’s much less likely to drop below our minimum return threshold. Looks like we might be ready to get our investing feet wet after all. Thanks, Arthur Roy.
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Finance: What is the Sharpe Ratio?6 Views
finance a la shmoop what is the Sharpe ratio well it's a calculation used by
investors in trying to figure out whether their investment was smart or [Sharpe ratio definition on 100 dollar bill]
just lucky or rather it's a measure to measure the amount of risk they took in [Smart and lucky on either side of balance scale]
order to get a given level of reward and remember risk and reward are joined at
the wrist like handcuffed politicians fighting for that one congressional seat [Politicians fighting over a chair]
in Alaska all right well for example if you spent five bucks on a lottery ticket
and won a million yes the outcome was mathematically good and yes you made 200
thousand times your money but was that a high Sharpe ratio investment no why
because your odds of winning were in fact one in a billion so you were just [Lottery billboard appears]
lucky like extremely lucky not necessarily good on the other hand what
if you had taken a deep dive and looked hard at Amazon in 1998 when it was [Woman with Amazon paper in library]
valued at a tiny fraction of where it's valued today well you could have done
the math on its profit margins which were nearly zero or negative for a very [Person using calculator]
long time you could have thought about how the public markets would perceive a
company growing revenues massively at such a level that in a decade they'd end [Amazon watering can sprinkles over revenues]
up beginning to destroy Walmart you could have looked at the amazing ease
with which product are delivered to lazy homeowners who love not having to get up [Man in frog onesie sitting on couch]
off their fat Duff's and drive to the store and park fighting crowds and angry
union cashiers who are upset to be bothered in the checkout line have you
done all this research and concluded that Amazon would go from a hundred [Amazon revenues graph rises]
million dollars in book sales to hundreds of billions of dollars of sales
of pretty much everything two decades later well then you would have done
high-quality research made a return analogous to your lottery ticket
winnings and maybe not two hundred thousand times but something close but
would have produced a very high Sharpe ratio because the quality of the
research and the risk management along the way was extremely high you also
could have gleaned that Amazon's growth when it was small was the envy of every [BestBuy and Oracle appear and look at amazon chart]
big-box retailer you know like Best Buy every technology firm like
Oracle and all the other establishment companies of the world from banks to
even oil companies probably certainly insurance companies such that for a
price amazon always would have been a relatively easy sale to one of those [Man taping up a box]
guys so that the downside on the investment all along the way was likely
a pretty limited so the bottom line high Sharpe ratios good research good smart
analysis good lottery tickets hugely bad very very bad
although investing in a company called chloroform energy drinks would probably [Man holds bottle of chloroform]
be even worse
