Monday, March 23, 1998

The Daily Workshop Report
by Robert Sheard (TMF Sheard)

LEXINGTON, KY. (March 23, 1998) -- With the recent back-testing work Jim Lynn has been posting in the Workshop, there are some misconceptions about precisely what the Sharpe Ratio measures.

The Sharpe Ratio is not a measure of risk and viewing it as one can be dangerous. Instead, the Sharpe measures a combination of returns, volatility, and a comparison rate of risk-free return (usually the treasury-bill return) to give us a handle on how well an investor would have been compensated during the measured time period for the amount of risk he accepted.

For example, a strategy posting a high Sharpe Ratio might well have done so with very high volatility but also very high returns. When compared with another strategy that has a lower Sharpe Ratio, it's not accurate to say that the higher ratio represents a "safer" approach. In fact, the opposite might well be true.

Let's look at an example. The Unemotional Value two-stock variation has an annualized return of 25.86% a year and a Sharpe Ratio of 76.14% since 1971. The Dow 30, on the other hand, has an annualized return of 13.66% and a Sharpe Ratio of only 44.84%.

Does this mean the UV2 is a safer strategy than buying the whole Dow? Absolutely not. If one of your two stocks collapses, your entire portfolio gets kicked in the teeth in a way that you'd hardly feel if that same stock were one of just 30 Dow holdings.

Don't get me wrong; safety first is often as bad in investing as it is in golf. Taking on prudent risk is the whole point of investing in equities. But don't get lulled into a false sense of security by a high Sharpe Ratio. It's one form of measuring a risk-adjusted return, but that's not the same thing as measuring risk.

If you have a strategy with a great Sharpe ratio, but the volatility drives you out of the strategy when the market slaps you around a bit, you'll get no comfort from the historically high Sharpe Ratio. Make sure you recognize that volatility may come with a high Sharpe Ratio package and you either need to be prepared to accept painful swings, or you'd be better off choosing a slightly less spectacular strategy you can stick with even in weak markets. For some investors, accepting slightly lower potential gains may be the right choice if it means they can sleep at night and ride out bad markets. Fool on!

Go Kentucky -- Final Four-Bound Again!

Check out the latest file updates for the Workshop:
New Rankings | 1998 Returns | New Database

[Robert Sheard is the author of the forthcoming book, The Unemotional Investor, due out from Simon & Schuster on May 12. To pre-order your copy, please visit Amazon.com, where it's available at a discounted price.]