Our portfolios and risk  ‍

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When discussing stocks the word “risk” is thrown around quite a lot. For many this vague term is used to describe the amount of capital we invest or ambiguous penny stocks that “could” rocket (according to your weird fucking uncle).

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However, risk is a very real and computational variable, that could help you decide if that stock is worth adding to your portfolio. Or give you the ability to decide your risk level.

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Calculating risk.

The Sharpe ratio is one of the most widely used methods for measuring risk-adjusted relative returns. In simplistic understandable terms the return on your investments compared to the risk taken to earn those returns.

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This next part may get slightly nerdy…... it’s worth it (I’m sorry).

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‍Sharpe Ratio.

The Sharpe ratio is the portfolio/stock risk premium (which is just the expected or mean return of the stock minus the risk-free rate of return) over the standard deviation of the stock or portfolio.

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This may sound overwhelming, But in all honestly, it’s simple. The expected return and standard deviation are easily calculated using the mean and standard deviation function in excel, so all you need to do is download the data. If that’s too much for you, there are plenty of calculators online.

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My preferred method is by excel as it makes you feel like the real deal….. Michael Burry who ? My bitch that’s who.

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The aim is to have the higher Sharpe ratio. The higher the Sharpe the better your stock or portfolio looks ! (a motto for life, higher = better) .

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The “Why”

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Congrats on getting past the schoolwork, now to understand why the fuck I’ve told you about this. The way I like to explain it. Is If you have two investments that both return 10% over the long run, it's better to pick the one with the higher Sharpe ratio, because it will have a smoother ride to the same place. The other one, if it has a low enough Sharpe ratio, will get there but you may be using the air-sickness bag during the trip. Meaning - you may get shaken out.

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The equation also lets you decide your risk tolerance. As someone whose relatively young my investment strategy allows for a lot of risk as I will never have as little responsibility as I do now. This brings us back to a previous concept from another one of our articles (click here). Which talks about “making a fucking plan”.

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For me its small stocks with potential to grow. These “penny stocks” can be built up with 90% of crap. However, the Sharpe ratio allows me a way to navigate that and not just bet blind.

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I like to use a refinement of the Sharpe ratio called the Sortino ratio. I pretty much select all my investments using it. You can compute the aforementioned (and Sharpe) using PortfolioVisualizer.com. Sortino only accounts for downward volatility, if a security is very volatile while it is taking huge leaps upwards, why would I care about that? 🤑

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Limitations

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The limitation of the Sharpe Ratio is that it just tells you that one investment was better than the other comparing risk but does not tell you HOW MUCH better that investment was. In other words, there are no units to measure the added benefit from choosing one investment over another.

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That’s All Folks

I appreciate you getting this far with me fellas. It was some ride.

It goes without saying there is no substitute for good through research. But if the investing game is like a war. The Sharpe ratio is another weapon to your arsenal.

Not Financial advice, I hear colors. Full disclaimer here

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Cheers,

Dawson