Sharpe Contrasts
Using the sharpe ratio to determine risk adjusted returns.
Despite the financial services industry’s progress towards planning – be it through legislation, the proliferation of low-cost index funds and exchange traded funds, or a wiser consumer altogether – our industry still has an identity crisis. Advisors still place their value to an investor through the lens of performance alone, often taking credit for their outperformance over a period without being able to clearly explain what attributed to that outperformance (and therefore less likely to be able to repeat it…) in the first place.
In my observation, performance is indicative of risk versus reward, and luck versus skill. Let me break those two distinctions down.
In the world of investing, there’s something called equity risk premium. Equity risk premium is the additional return an investor seeks by taking on a greater level of risk above a safer alternative – called the “risk free rate” – which in most cases is the US Treasury Bill (T-bill).
Equity risk premium says the more you risk, the more return you should demand (and theoretically receive) from your investments overtime, above the risk-free rate. The downside is ever apparent in the year 2022: the more risk that is taken, the more variable the swings in your portfolio value are, or worse yet – the higher your probability for the ultimate risk experienced – that is, a permanent loss in capital.
When pitting two portfolios against one another (for simplicity’s sake – we’ll call them portfolio A and portfolio B…) the performance alone does not tell you much if the level of risk is not understood:
Hypothetical Portfolio A: 60% US Stocks, 40% T-bills. Average rate of return, trailing 10-year, was 10%.
Hypothetical Portfolio B: 60% US Stocks, 40% T-bills. Average rate of return, trailing 10-year, was 12%.
Portfolio B is the clear winner. But what if the risk taken was dramatically higher for portfolio B? And what if a third variable is entered into the equation – that the investor is also withdrawing from the portfolio? We would want to know what the risk-adjusted return was. There are different methodologies you could use to measure risk-adjusted return. Perhaps one of the easier ones to calculate would be the Sharpe Ratio.
The Sharpe Ratio is equal to the return of the portfolio, less the risk-free rate, divided by the standard deviation (i.e. how much did a portfolio’s return vary from its average?). Here’s a quick example given by BlackRock[i]:
The higher the Sharpe Ratio, the more efficient the portfolio was with the risk that was taken. Portfolio B still got you there, but it was a wild ride. Portfolio A not only got you there but was more predictable along the way.
Now let’s consider luck versus skill. Luck is what you have when you take $100 to a casino, sit down at the roulette table or craps table for an hour, and walk away with $150. That 50% increase was a component of mostly luck – you cannot roll the dice differently to influence a more favorable outcome or see the future as to whether black or red will next hit at the roulette table. You cannot attribute any of your gains to skill – it was (mostly) luck.
Skill in the investment world is being tested like never before. Because information moves so quickly today, there is no longer a premium on information. In other words – most parts of the markets are incredibly efficient. Today, investment skill is the ability to weigh short term risks that might distort the equity risk premium discussed earlier and to limit those risks (underweight them) in favor of something else (overweight elsewhere). The end goal is to hopefully keep the equity risk premium about the same, while reducing the risks.
As discussed in my Thanksgiving letter to investors, this is almost an impossibility in the short term. It’s no wonder that the consensus view is to be underweight stocks – it would be career suicide right now to suggest differently. There is such a wide range of outcomes over the next 12-18 months, which is why it is so important to keep a long-term perspective, while also weighing the risks involved with investing more heavily over the short term.
The value of an advisor is the ability to distinguish between the two – did I outperform over a period due to luck or skill, and did I outperform over a period due to more risk being taken, or the same level of risk taken? This is where a truly established and knowledgeable advisor should be able to add value from a performance perspective. It’s not necessarily to outperform all the time, but to be able to help investors decipher what investment data and statics is most critical to them, for the outcome they are looking to achieve. Lastly - your advisor should be able to clearly articulate why the returns were what they were, and how much risk was assumed to get you there.
[i] https://www.blackrock.com/ca/investors/en/market-insights/risk-adjusted-return?switchLocale=y&siteEntryPassthrough=true
