For most people in the financial world, performance is key. When you see an ad for a mutual fund, the first thing you're likely to see is how well the fund performed in comparison to its peers or a broad index of similar investments. At the end of each quarter, you can expect to see lists of the best-performing funds in their respective categories. Performance is what gets a fund noticed; without good performance, a fund is likely to get lost among the thousands of other funds vying for a place in the portfolios of investors like you.
However, an essential element in evaluating any investment is knowing the level of risk involved. If an investment involves too much risk, then it may not be suitable for your portfolio even if it has the potential for high returns. Conversely, you may be willing to accept lower returns on an investment if its risk level is relatively low.
In order to take risk into consideration, you need to find a way to compare different investments that looks at more than just performance. One measurement, called the Sharpe ratio, can help you incorporate the risk of an investment into its overall return. By looking at the Sharpe ratios of different investments, you can better understand how much of an investment's return comes from the risks it assumes.
Measuring the Sharpe ratio
In order to calculate the Sharpe ratio, you need to know three things: the expected return on your investment, the current return available on a risk-free investment such as a U.S. Treasury bill, and the level of variation in your investment's returns as measured by the standard deviation of the investment's returns. If you use historical returns as a way of predicting your expected return in the future, then you can use a spreadsheet program or even some handheld calculators to determine standard deviation.
Once you know these three things, calculating the ratio is easy. The formula is:
Sharpe ratio = (excess return of your investment over the risk-free investment) / standard deviation
For instance, assume that one particular mutual fund has historically had an average return of 7% and a standard deviation of 10%, while a riskier fund earns a return of 10% with a standard deviation of 20%. With current risk-free rates of about 5%, the Sharpe ratio of the first fund would be (7%-5%) / 10% or 0.2, while the second fund would have a ratio of (10%-5%) / 20% or 0.25.
Drawing conclusions from Sharpe ratios
Comparing Sharpe ratios allows you to draw two interesting conclusions. First, a higher Sharpe ratio indicates that you are being better compensated for the risk you take. Using the example above, the second fund offers a better risk-adjusted return than the first fund.
More interestingly, Sharpe ratios can guide you toward better investment results. Again, consider the example above. The second fund has a better ratio, but it involves higher risk. If you are only willing to assume the risk of an investment with a standard deviation of 10%, you may conclude that your only choice is the fund with the lower ratio.
However, by creating a portfolio combining the second fund with a risk-free cash investment, you can obtain a higher return with the same risk. For instance, if you invest 50% of your money in Treasury bills and 50% in the second fund, you would earn 5% on half your money and 10% on the other half for a net return of 7.5%, with a standard deviation of 10%. On the other hand, investing in the first fund only provides a 7% return. By using the fund with the higher Sharpe ratio, you improved your return. Similarly, if you use a 60%-40% allocation, the mixed portfolio would have a 7% return, but the standard deviation would be 8%. This would mean that you could earn the same return as the first fund while assuming less risk.
The slippery concept of risk
In some ways, it's appropriate that performance generally takes center stage in the minds of investors. After all, at the end of the day, the thing you'll care about the most is how much your investment has grown. In contrast, the concept of risk is a difficult thing to understand. Because most investors focus on results, the idea that one investor may have assumed a different amount of risk to produce a given return doesn't generally seem important; if the risk didn't result in losses, then it may be difficult even to believe that it was ever there in the first place.
While it's easy to forget about risk during extended periods of prosperity in the financial markets, you only have to go back a few years to see the impact of risk on a portfolio. If you look at the performance of the index ETF SPDR Trust (AMEX:SPY) over the past 10 years, you'll see that its price has risen from $76 to $140, with another $15 in dividends paid along the way. That's a healthy return of roughly 8% per year. However, consider the ups and downs that investors went through in order to earn that 8%. Returns exceeding 20% during several years in the late 1990s were followed by three straight years of declines, only to be followed by another strong performance in 2003 and consistent gains over the last three years.
Unfortunately, even the Sharpe ratio has limitations in its use. While determining Sharpe ratios for investments using historical data is a simple exercise, extrapolating these backward-looking measures of risk into the future will not necessarily give you the right answer. Just as past performance is no guarantee of future results, past levels of risk don't necessarily ensure that a certain level of safety will persist into the future.
As a way to incorporate risk into your investment analysis, the Sharpe ratio does a good job of going beyond straight performance figures to give you insight into how an investment was successful. Even with its limitations, the Sharpe ratio is a useful tool to consider in selecting your next new investment for your portfolio.
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Finding mutual funds with strong returns and reasonable risks is the primary mission of Motley Fool Champion Funds. Foolish fund expert Shannon Zimmerman scours thousands of funds to find the ones best suited to his readers' portfolios. To see how Champion Funds can help you with your fund investing, take a free look with our 30-day trial.
Fool contributor Dan Caplinger focuses on risk, though he never begrudges a nice return when it comes. He doesn't own shares of SPY. The Fool's disclosure policy will help you stay sharp.
