If you choose investments based on total returns over specific time periods (ie, 1 year, 3 yrs, 5 yrs and 10 yrs), without assessing the risk, it's time to meet your selection to add another component .
Standard Deviation and Sharpe ratio are two basic tools used by professional investors to determine risk and, with a little practice, you can use it too.
Although standard deviation is not limited to the field of investment, it is a measure of the volatility that translates into danger. High standard deviations indicate a wide range of investment returns and low deviations indicate a narrow range of returns.
A word of warning: standard deviation will not do you much good unless you use it to compare among other investments as the standard deviation. Taking things a step further, if you compare the standard deviation of a benchmark (ie a standard deviation indices), you can see how closely these investments perform their benchmark for a risk-adjusted basis.
Now for the fun part. Let's calculate standard deviations using hypothetical investments:
Suppose Large Cap Investment A has a 9% average return over a period of three years (the most common time frame for measuring the standard deviation). Also assume that a standard deviation of 6.
Now also assume that the Large Cap Investment B has an average return of 9% compared to the same three-year period, but that it is a standard deviation of 7.
For the range of returns for our hypothetical investments are, you need to take the average rate of return and add (or subtract) the standard deviation for that investment. The result gives you the range of returns for that investment 68% of the time.
In our hypothetical example above, while both investments have a 9% average return, Investment A has a range of return of 3% to 15%. Investment B has a range of efficiency of 2% to 16%. Because Investment B has a wider range of performance, would be deemed to be the more volatile (or risky) of the two investments.
Now let's look at a hypothetical benchmark to compare these investments. Let's assume that the market return for Large Cap Investments is 7.25%, with a standard deviation of 5.5. Using the above formula, the benchmark set of efficiencies for Large-Cap Investments 1.75% (7.25% minus 5.5) to 12.75% (7.25% plus 5.5) are.
So far so good, but how can we compare Investment A (with a 9% average return and standard deviation of 6) to the benchmark (with a 7.25% average return and standard deviation of 5.5)? Before we look at the Sharpe ratio.
Developed by Bill Sharpe, the Sharpe Ratio tries to quantify. Risk of an investment in relation to its investment return The higher the ratio, the better the performance of the investment after adjusting for its risk.
Our formula takes the difference between the return on a particular investment and the return on a risk-free investment. This difference is divided by the standard deviation. That should give us the answer.
Although no investment is truly risk free, let's use a low-risk, 90-day Treasury Bill, with an average yield of 2%.
Our Sharpe Ratio for Investment A would be as follows:
9 (Investment A's average return) minus 2 (average yield T Bills) = 7 (Excess return over a risk free investment)
7 (Excess return over a risk-free investment) divided by 6 (Investment A's standard deviation) = 1.67 (Sharpe Ratio)
Our Sharpe Ratio for the benchmark would be as follows:
7:25 (average yield Benchmark's) minus 2 (average yield Bills T) = 5.25 (Excess return over risk free)
5:25 divided by 5.5 (Benchmark's standard deviation) = 0.95 (Sharpe Ratio)
Because Investment A has a higher Sharpe ratio (1.67) than the benchmark (0.95), it is considered a better risk adjusted returns have.
If you want more information on the standard deviation and the Sharpe ratio, there are several sites on the internet that will be happy to accommodate you.
Remember, these are just two tools used in the process of selecting securities. They are not infallible, but they can be effective in keeping your portfolio in top-notch shape. Tremendous help
Glenn (? Chip?) Dahlke, a senior contributor to the Living Trust Network, has 28 years in the investment business. He is a Registered Representative of Linsco / Private Ledger and a principal with Dahlke Financial Group. He is licensed to securities transactions with persons who are residents of the following states: CA. CT, FL, GA, IL. MA, MD. ME, MI. NC, NH, NJ, NY.OR, PA, RI, VA, VT, WY.
If you have any questions or comments, Chip would love to hear from you. You can t with him e-mail contact. You can also contact him at the Living Trust Network. Her website is
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