- Check you're not taking too much risk
- Try to beat the market without recklessness
Diversification, famously, is described as the ‘only free lunch’ for investors. Most basically, it’s sensible to keep your eggs in more than one basket, but if you fancy turning a nourishing staple into a really tasty dish, it’s worth adding a dash of something extra.
Post-modern innovations are the cordon bleu of investment management. Our booking for that swanky menu is reserved for a later article in this series. Before then, the latest instalment of our portfolio theory tour looks at some older breakthroughs that have become key ingredients.
Debts of gratitude are owed to pioneers such as Harry Markowitz, William Sharpe, Jack Treynor, Michael Jensen and Robert Merton for their work in developing the framework. We’ve discussed some of the basics of modern portfolio theory (MPT) and the capital asset pricing model (CAPM) it inspired in previous articles. Many of the names above also provide insights that can be gleaned studying the ratios they invented, and which bear their names.
A Sharpe way to assess performance
Most widespread and, perhaps, most influential, the Sharpe ratio redefined investment benchmarking. Central to the CAPM is the idea that investors can invest or borrow at a risk-free rate of return (usually the yield to maturity of a quality sovereign government bond). Investors accept risk to have a chance of outperforming this rate. Sharpe’s logical assertion is that portfolios should be judged on how they do versus the risk-free rate and relative to the risk taken (measured as standard deviation of returns).
Through smart asset diversification, an investor can massively improve a portfolio’s risk-to-reward profile. Within the part of that allocation dedicated to shares, it’s possible to take less risk and achieve objectives and maybe even beat a benchmark index in absolute terms, too.
Believers in mean reversion might use historic risk and return data to optimise portfolio weightings to achieve the maximum Sharpe ratio. Trying to be forward thinking, a more advanced method would be to use projections of returns and risk (with the latter being hard but not impossible if derived from options pricing). Perhaps we can attempt such a challenge later in this series.
Risk and benchmarks
Another metric that’s similar, but most easily applied to the shares portion of your asset allocation, is the Treynor ratio. This expresses risk in terms of beta, which is the portfolio’s volatility relative to that of a benchmark index.
Ordinary investors are most concerned with potential for losses caused by falls in the value of their portfolio. Expressing risk in terms of these peak-to-trough drawdowns, the Calmar ratio takes 'max drawdown' (the worst fall) as its denominator, whereas the Sterling ratio uses average drawdowns.
Good portfolios, in summary, should beat the risk-free rate and do so convincingly relative to the risk taken. Furthermore, this feat should be achieved more impressively than a benchmark index to prove skill in active investment management.
Alpha is the portion of returns that can’t be explained by how the benchmark has performed. Returning to the principle of beating the risk-free rate – to achieve positive risk-adjusted returns – Jensen’s Alpha is an interesting yardstick.
This ratio posits that true alpha is how much the portfolio beats what the portfolio’s beta suggests investors ought to expect given its riskiness versus the benchmark.
Another useful statistic for comparing portfolio and market returns is the M² which computes a risk-adjusted percentage.
The difference between M² and the performance of the market is the M² alpha. This figure is used by professional portfolio managers as a way to peer-review performance.
For individual investors, however, the impetus is somewhat different. Career risk isn’t the issue, rather it’s the risk of missing cherished objectives along with the aforementioned fear of deep peak-to-trough drawdowns in portfolio value.
Fortunately, post-modern portfolio expresses downside risk in relation to a target rate of return. It’s these ratios, along with that crucial question of an investor’s utility, that we shall look at in the next part of our series.
