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How important is the 'Sharpe Ratio'?

Trading Guides

How important is the 'Sharpe Ratio'?

The Sharpe ratio is commonly used to gauge the performance of an investment by adjusting for its risk.

September 26, 2021

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How do I measure risk vs reward?

We feel that everyone would appreciate The Portfolio Platform even more, if we took the time to explain the most important analysis tools used to evaluate each trader and their performance.

We have given a brief overview but today I would like to go into a little more depth about what is possibly the most important method of measuring risk reward, the Sharpe Ratio. Now this may sound like a complicated method best left to the fund managers to decipher, but it really isn’t. It’s very simple and well worth knowing.

What is the Sharpe Ratio?

Named after American economist, William Sharpe, the Sharpe ratio is commonly used to gauge the performance of an investment by adjusting for its risk.

The higher the ratio, the greater the investment return relative to the amount of risk taken, and thus, the better the investment. The ratio can be used to evaluate a single stock, or an entire portfolio.

What Does it actually mean?

It is all about maximising returns and reducing volatility. Anyone who has been a user of TPP over the last year is beginning to realise that volatility can quickly increase when times are ‘uncertain’. We have seen huge volatility swings over the last 12 months, and the current climate makes a good Sharpe Ratio even more relevant to picking an investment.

If an investment had an annual return of 10%, but had 0% volatility, it would have an infinite Sharpe ratio, as in theory, there would be no risk. Sadly, this is not a thing, and no such investment has ever been a certainty. If it were, our lives would all be a lot simpler and we’d all be a lot richer.

Even government bonds, one of the least risky investments, have been incredibly volatile recently. The German 5-year bond has a current yield of -0.56%. This means if you buy one, and hold it to maturity, you will be guaranteed to lose -0.56%. You may find this incredulous, and maybe this is a conversation for another time, but what you’ll find even more unbelievable is just how many your pension owns.

This is the disaster of the IFA risk model. It doesn’t matter what the return is, if the computer has you as a risk rating of 6, considered aggressive, you will hold a surprising amount. Even my own pension, which I have at the highest risk rating, still holds 4% of the portfolio in government bonds. I don’t want them, but I don’t have a choice. That is the model, that is what the computer says, so that is what you have.

I have also just had my Q1 pension report through, and it was up 0.6%!  Compare this to my Portfolio Consultancy Global Equity strategy which is up 15.3% in the same time. Still, we are told a pension is something we must have, and so we do not question it. Having said that, the problem with a pension isn’t so much that we have one, but the restrictive rules in place for those managing them.

The government/FCA do not trust the average person to make the right decisions, so they take away control of their finances wherever possible, and run a computer model that dictates investment asset allocation instead, so that nobody is accountable. The market goes down, so does your pension. End of story, it’s the markets fault not theirs. Your IFA feels no guilt because they did nothing wrong. That is where TPP stand apart, as we actively trade, long and short, and make the traders available to anyone.

Anyway, I digress, back to Sharpe ratios.

The actual equation of a Sharpe ratio is the average investment return, minus the risk-free rate of return, divided by the standard deviation of returns for the investment. This now sounds a little more complicated, but it’s not, as long as you know the variables. On The Portfolio Platform this is all worked out for you, and the Sharpe ratios are stated on each individual tile page of the trading team.

Isn’t a higher return just a better strategy?

Not necessarily if you take into account the fact that it has to be divided by the standard deviation or volatility of the asset.

Consider two fund managers, Andrew and Helen. Andrew has a return of 10%, while Helen has a return of 20%. Although it looks like Helen’s performance is better in terms of return, when we look at Sharpe ratio, Andrew’s is 2.0, whereas Helen’s is 0.5.

How is this possible? The risk taken by Helen to get the 20% return, is more than double the risk taken by Andrew to get his 10% return.

From this, we can actually infer that Andrew’s fund over time, should perform better when compared to his risk. If he had doubled his risk, he would have made 20% but with less price fluctuation than Helen.

So, what numbers should you actually be looking for?

Generally speaking, you’d be surprised at how low the Sharpe ratio numbers are for most funds. Let’s look at a selection of the best performers and compare them to The Portfolio Platform.

Gary Robinson, Baillie Gifford: 1.49
Jeremy Gleeson, AXA Global Technology: 1.23
Alison Porter, Janus Henderson Global Technology: 1.19

To put these into perspective, Schroder UK Dynamic Smaller companies Fund has a 3-year Sharpe ratio of 0.44.

Now let’s compare them to the top 3 on The Portfolio Platform

European Stock Basket: 3.62
Value Driven Growth: 2.4
Cambridge Futures: 1.82

These are simply the statistics and the facts. We can’t make them up as all trades are automatically logged and the results recorded by our software. The cost of linking your account to any of these portfolios is $100 (less than £75) per month. That’s it. No performance fee and no management fee.

All it takes to have your portfolio Autotraded by any of our world-class traders, is your own broker account. Then, you simply register here, subscribe, and link. Your portfolio will then, quite literally as far as you’re concerned, trade itself.

Register now and set up your free simulation demo account to watch the trading as it happens. You can only see the detailed positions once you have subscribed, but any registered user has access to daily profit and loss, as well as a description of each trading team and the relevant statistics including Sharpe ratio.

It’s time to take control of your capital, and join the new world or investing.

At The Portfolio Platform we only have the best traders we can find and they are available to you to autotrade. Let them make the hard decisions so you don’t have to. We are providing the middle ground between hedge funds, and retail investors. It’s professional trading, for the average investor. For a free simulation account, sign in here. You can monitor the traders and see the results for yourself before taking the next step and building your own, personalised fund built up of traders selected by you, but already vetted by us.

If you would like to find out more, schedule a call with our team- click here.

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