Better Way to Check Portfolio Risk
From: financial-planning.com
There’s a perception that strong portfolio performance naturally comes at the price of higher volatility. But what if achieving strong performance with lower volatility is possible?
The Sharpe Ratio was developed years ago to evaluate risk-adjusted performance, highlighting the importance of considering returns in the context of volatility. The ratio compares the return of an asset above the risk-free rate — that is, its “excess return” — against the standard deviation of the excess return.
The higher the Sharpe Ratio, the better.
The basic idea is that a given level of return achieved with less volatility is better. Yet it’s a complex calculation, so let me suggest a simpler approach. I’m calling it the pain-to-gain ratio, or PGR. We want to experience less volatility (pain) for a given level of return (gain) — so the lower an investment’s score, the better.
In this approach, we simply divide the standard deviation of return by the return. Take this example: If Fund A has a 20% standard deviation and a return of 10% and Fund B has a 10% standard deviation and a 10% return, Fund B is the clear winner, with a 1.0 PGR vs. a 2.0 PGR for Fund A. The lower the PGR, the better.
COMPARING PORTFOLIOS
I calculated the ratio for three different investment portfolios over 36 10-year rolling periods, from 1970 through 2014. The first was 100% U.S. large-cap stock, representing a minimally diversified investment model. The next was 60% U.S. large-cap stock and 40% U.S. bonds (rebalanced annually), and the third was a seven-asset model that included large- and small-cap U.S. stock, non-U.S. stock, real estate, commodities, U.S. bonds and cash — all in equal 14.29% allocations and rebalanced at the end of each year.
Performance was calculated using index data for each asset class.
In the first 10-year rolling period, 1970-79, the 10-year annualized return for 100% U.S. large-cap stock was 5.88%, and the 10-year standard deviation of annual returns was 19.24% — producing a PGR of 3.27.
The 10-year annualized return for the 60/40 portfolio was 6.7%, with a 12.24% standard deviation, for a PGR of 1.83. And the seven-asset portfolio had a 10-year annualized return of 11.71%, a standard deviation of 9.65% and a PGR of 0.82.
For this period, the seven-asset portfolio was the superior approach, with the highest 10-year return and lowest standard deviation.
As you can see in the “Comparing Approaches” chart below, this multi-asset portfolio proved to be the strongest overall over the 45-year period — at least on the basis of rolling 10-year periods.
