Increasing Results Using Risk-Aware Investing
Posted by Don Martin on Thu, Jan 13, 2011 @ 07:18 PM
Risk-aware investing means to judge an investment by its risk adjusted rate of return. This means using Sharpe ratio or Information ratio to see how much reward did you obtain in return for the risk you took. The goal is to spot investments that had a high performance but were so risky that they really did not make enough profit to offset or to justify taking the risk. Using this technique means an investor may make less than another investor who takes on excessive risk however an investor who uses risk-aware techniques may be able to reduce the probability of serious losses. However, nothing about investments is guaranteed and past performance is not indicative of the future.
The theory behind risk aware investing is to take reasonable risks and to avoid unreasonable risks. A simple technique would be to sort investments by Standard Deviation and reject those in the highest quartile, or possibly reject those in the highest half. This would result in a lower rate of return but would increase the probability of avoiding catastrophic risks. Some experts believe that the most important goal in investing is to avoid losing money. For example, if you have $100 invested and lose 50% then when the investment that is now worth $50 later goes up by 50% you now have only $75.
How does the Sharpe ratio work? It subtracts the T-Bill rate of return from the investment’s return and divided by Standard Deviation of the investment. This shows how much alpha (excess return) you got divided by the amount of risk. This allows you compare reward in proportion to risk. The problem is that today T-Bills are close to zero yield. Further, the excess or alpha return that you got from the investment should be compared to the same asset class. For example, if you invest in large cap domestic stock then instead of using T-Bill rate to determine alpha, use the large cap average rate of return to determine what your investments alpha was. This is done using the “Information ratio”, which uses a benchmark that is similar to the asset class you are examining to determine alpha. This is a crucial difference between the Sharpe ratio versus Information ratio during eras when the Fed is making interest rates artificially low.
The challenge is that past booms can lead to bubbles so that the investment with the best Sharpe or Information ratio in the past may have reached its peak and will be ready for a crash if it is overpriced. So you can’t simply look at what stock had the best Sharpe or Information ratio, you also have to examine the intrinsic value by looking at the 10 year P.E. ratio to see if it is reasonably priced and you need to look at the possibility of the “value trap” phenomenon which occurs when a stock is declining the p.e. ratio looks better but the stock is in danger of collapsing. In addition it is important to look at corporate financial health, corporate moat, return on equity, growth rate of sales and earnings. Also, if interest rates are set by the Fed at historic lows then they may have temporarily and artificially increased the value of the stock market, which will put downward pressure on stocks, once the Fed raises rates to normal levels.
This is an example of independent investment advice.