I talked about the Standard Deviation as a tool for measurement of risk in investments and will discuss very briefly another tool used by professionals: The Sharpe Ratio.
Most of us look at the returns and don’t focus on the risk we take in trying to achieve those returns. The Sharpe Ratio helps investors calculate out how much return they're getting in exchange for the degree of risk they're taking. Stanford Finance Professor and Nobel Laureate devised the ratio to figure out the investment return for each unit of risk assumed. So, SR = Investment (fund) return – presumed return on risk free investment/ volatility as measured by the standard deviation (we talked about in April, still posted on the blog) So, a high S ratio means you are getting rewarded well in proportion to the risk you took.
Example: Assume Treasury yields are 0.5% (if you are lucky!!) My fund earns 12% annually but I took a higher risk and my SD was 30%. So, my S ratio was 12-0.5/30 or 0.38 Your fund gave you only 10% annually but your risk was less and the SD was only 20%. Your Sharpe Ratio was based upon 10-0.5/20 equals 0.47. Your fund delivered a better return in relation to the risk.
You can find this ratio in most funds and if you use Morning Star it is under the ‘ratings & risk’ tab. Downsides are that this looks at past performance only and loses some relevance if returns are at Treasury Rates or below. This is just an additional tool for you to use in assessing risk versus reward. Next, I will talk about some other risk metrics such as Alpha and Beta.