Roy's Safety-First Criterion - SFRatio

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.