The Daily Dow
Wednesday, May 28, 1997
by Robert Sheard (TMF Sheard)
LEXINGTON, KY. (May 28, 1997) -- The concept of risk and risk-adjusted returns is one that's confused many readers of late, so let's look at what the Sharpe Ratio really measures.
A lot of readers have seen the annual average return for the Unemotional Value two-stock approach (25.81% since 1971) and their eyes have fallen out. And then when they see that the Sharpe Ratio is extremely high (82.14 versus 46.50 for the Dow 30), they mistakenly assume it's the "safest" of all the variations as well. But this isn't the case.
The Sharpe Ratio is not a pure measure of the risk one takes with a specific investment approach. What it does measure is how well one has been compensated, relative to alternatives, by taking on the risk associated with that approach compared to a benchmark of risk-free returns. So with a very high Sharpe Ratio, a strategy isn't necessarily safer than another with a lower Sharpe Ratio; it just means that for the level of risk you're taking on, you've been compensated well for it.
Let's look at the common-sense risk of a two-stock portfolio. Although it hasn't affected the history of the UV2 approach (over the course of our data anyway), having 50% of one's portfolio in a single stock is an invitation for disaster if something drastic does go wrong. The fact that it hasn't happened in recent memory is no guarantee that it can't happen tomorrow or next year.
So, don't associate the Sharpe Ratio exclusively with risk. A two-stock approach, even one with great historical returns like the UV2, is still riskier than a 10-stock Dow Approach, even though it produces lower returns.
The question each investor must wrestle with is how much risk he or she can accept in the quest for higher returns. My personal belief is that, even with the Dow stocks, a five-stock portfolio should be the most concentrated you should ever accept. The Foolish Four and the other, more concentrated, Dow Approaches work well as parts of larger portfolios where you might hold ten to fifteen stocks. But for investors who are only investing in the Dow stocks and using it for their entire investment strategy, five stocks is as concentrated as I'd be willing to go unless it were a very small account you're just starting to build and you'll add stocks as it grows.
But that's my risk tolerance. Yours may well be different, so adjust the limits to your own needs. But I felt it necessary to clear up the idea running through some recent posts to our message boards that mistakenly assumed the Sharpe Ratio was a pure measure of risk.
On a final note, Big Blue split two-for-one this morning. IBM <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IBM)") else Response.Write("(NYSE: IBM)") end if %> still trades close to $100 a share, even after the split, an all-time
high for the stock. Fool on!
(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool. ________________________________
Stock Change Last -------------------- T - 5/8 36.88 GM - 1/4 57.75 CHV - 1/8 70.13 MMM +2 93.00
Day Month Year
FOOL-4 -0.24% 5.74% 1.00%
DJIA -0.35% 4.97% 14.10%
S&P 500 -0.29% 5.72% 14.37%
NASDAQ +0.07% 11.85% 9.23%
Rec'd # Security In At Now Change
1/2/97 120 3M 83.00 93.00 12.05%
1/2/97 153 Chevron 65.00 70.13 7.88%
1/2/97 179 Gen. Motor 55.75 57.75 3.59%
1/2/97 479 AT&T 41.75 36.88 -11.68%
Rec'd # Security In At Value Change
1/2/97 120 3M 9960.00 11160.00 $1200.00
1/2/97 153 Chevron 9945.00 10729.13 $784.13
1/2/97 179 Gen. Motor 9979.25 10337.25 $358.00
1/2/97 479 AT&T 19998.25 17663.13 -$2335.13
CASH $609.53
TOTAL $50499.03