The Power To Perform: mhj3.com Managing Investing Judgment Since 1989

Investing Fools' Tool # 5: Dull Sharpe Ratio

Think about it: 'Past investment performance is not an indicator of future investment results' is a required, responsible, and absolutely true investing footnote, an investing fact that anyone who has spent more than a nanosecond in the financial markets would or should know, and an investing law designed to protect the investing naive, innocent, and unsuspecting.

Then why would one blindly place his/her trust in the present and his/her hope for the future in a mythical investing science — Modern Portfolio Theory and all of its illegitimate relatives such as Monte Carlo Analysis, Efficient Frontier Analysis, Beta, Brinson's Asset Allocation, Pie Charts, and a distant relative, Technical Analysis (worth a glance) — that relies solely on past performance investment data to feed hypothetical and contrived investing algorithms in a misguided effort to predict future investment results?

All are just other ways to record and to illustrate investment history without valid analytical, interpretive, deductive, predictive, or directional investment value.

If this nonsense were valid, there would be no need for investing analytics, forecasting, or guidance of any kind — research, analysis, opinion, advisors — and one would simply select investments based on past performance without regard to suitability, quality, structure, or risk.

Explained another way, a thermometer measures temperatures in degrees as the weather changes.

A thermometer is a recording device not a forecasting one and, therefore, it cannot be used to predict future temperature levels.

Standard Deviation, Efficient Frontier, Beta, VaR, and Sharpe Ratio are much like a thermometer; merely means to measure past (contrived) relative investment performances between investment variables and neither the cause of nor the predictor of either.

Furthermore, if a thermometer also happened to store prior temperature readings on a daily basis, you certainly would not retrieve that information and use it to predict tomorrow's or next week's temperature readings.

As one would have to analyze the weather-changing causal variables that affect weather, such as humidity and barometric pressure, to predict future temperature levels.

The same holds true for historical Standard Deviation, Efficient Frontier, Beta, VaR, and Sharpe Ratio readings as a basis for predicting the investing future.

Future investment values and associated investment/investing risks can only be meaningfully understood and predicted based on one’s correct understanding and interpretation of the fundamental performance changing, causal investment performance variables that actually affect an equity’s behavior.

Keep in mind, there is no theory — modern or otherwise — that can be ordained, no computer that can be programmed, no software that can be designed, no investing tool that can be 'imagineered,' no technical analysis voodoo methodology that can be contrived, and no equation that can be divined to quantify, evaluate, and predict the primary forces that drive the sublime chaos of the financial markets and investment prices; human consensus, mood, and behavior; intelligent and not, knowledgeable and not, reasoned and not, rational and not, and logical and not.

Sharpe Ratio

The Sharpe ratio is a theoretical means to tells us whether an investment portfolio's returns are due to smart investment decisions or a result of excess investment risks.

Modern Portfolio Theory

Before one even considers the possible validity of and the use of Sharpe Ratio investment analysis, one must first question the general validity of the notion of Sharpe Ratio as part of Modern Portfolio Theory and then consider specifically the validity of and the use of its structural linchpin assumptions:

Modern Investing Math Mystique

In general, there is an ever increasing and unexplainable modern investing math mystique investing equation phenomenon; if what seems to be or is defined to be a cause and effect occurrence expressed as a mathematical equation, the equation is assumed to be, must be valid, universally true, and has unique predictive powers.

'Einstein's theory of relativity seems to be valid:'

'Certainly If is valid and reflective of actual cause and effect variable relationships and is, therefore, predictive of behaviors in the universe, then surely the latest iteration of the Beta risk measurement equation below — much more complex, with many more variables than Einstein's equation — most certainly, must be, just has to be valid.'

From: Beta = [Cov(r, Km)] / [StdDev(Km)]2

To:

'Wow, look at this one, honey.'

'Let's put all of our life savings into this equation!'

'It just has to work!'

'Therefore, the Sharpe Ratio equation, which looks as simple as Einstein's math, most certainly must be valid.'

'I had no idea investing is this easy.'

Expected Returns (Investopedia)

The calculation of 'Expected Returns' is based 100% on past performance; utter nonsense:

How do you calculate the average of a probability distribution?

As denoted by the above formula, simply take the probability of each possible return outcome and multiply it by the return outcome itself.

For example, if you knew a given investment had a 50% chance of earning a 10% return, a 25% chance of earning 20% and a 25% chance of earning -10%, the expected return would be equal to 7.5%:

= (0.5) (0.1) + (0.25) (0.2) + (0.25) (-0.1)
= 0.075
= 7.5%

'Simply take the probability and multiply it by the return outcome itself.'

I understand the instructions of the sentence; the math is easy.

But, it's the variables of 'probability' and 'return outcome' where you lose me; source and based on what?

The past?

Not a chance!

What do you mean, 'if you knew a given investment had a 50% chance of earning a 10% return?'

  • You don't know, nobody knows; therefore, 'validity of and the use of' are out window!

And you wonder why most investment advisors and investors underperform most markets most of the time!

Volatility/Variability

Volatility: The amount of uncertainty or risk about the size of changes in a security's value.

Variability: The possible range of outcomes for any given event.

Volatility and Variability are not valid investment risk measurements; many investments with low volatility/variability have gone out of business and many investments with high volatility/variability have flourished; GM and GOOG are two of thousands more often than not examples.

Past Performance

All Sharpe Ration calculation variable assumptions, observations, and conclusions refer to investment/portfolio performance in the investing past; however, there is no cause and effect relationship, other than coincidental, between the investing past and investing future that could possibly lead one to conclude that the investing future can somehow mystically (mathematically) be found in, derived from, or connected with the investing past; investing hindsight is neither investing insight nor investing foresight.

Dull Sharpe Ratio

The Sharpe Ratio is used to characterize how well the return of an asset compensates the investor for the risk taken, the higher the Sharpe Ratio number the better.

 

"Most risk measures are best described graphically; a measure of return in the vertical axis and a measure of risk in the horizontal axis as shown above."

  • The graph to the right (copied from Investopedia) is simply a visual and mathematical presentation of the 'verbal obvious;' conservative investors want no risk (U.S. Treasury) or low risk suitable investments (Portfolios A", A', or A) that will generate the best returns (therefore, Portfolio A" is the best conservative portfolio — same risk as A' and A; but, a higher return) and aggressive investors, willing to assume more (Portfolio B) or a lot of or extreme investment risk (Portfolio C), want suitable investments that have the potential to reap higher returns.
  • If you are a conservative investor, willing to move beyond 'U.S. Treasury,' who wouldn't want Portfolios A, A', or A;" and of the three, A" over A' or A? If you are an aggressive investor, who wouldn't want Portfolio B or, better yet Portfolio C?
  • The issue is not what you want; whether presented graphically as illustrated by the Investopedia image above or verbally; that's easy and obvious.
  • It's the detail of how you are going 'to get there' that is important; based on what?
    • Past performance, expected returns, volatility, variability, Sharpe Ratio?
    • Investment fundamentals, quality, value, simplicity, suitability, due diligence, attention to detail, investment selection and portfolio management disciplines, rules, and procedures that govern the dynamics of change, the ongoing decision making, action taking investing processes , 'best efforts' investment timing, ongoing management, and patience; the investing performance excellence edge that will take the investor to his/her investing destination?

"When comparing assets each with the expected return E[R] against the same benchmark with return Rf, the asset with the higher Sharpe Ratio gives more return for the same risk."

The Sharpe Ratio simply measures the gradient of the line from the risk free rate (the natural starting point for any investor) to the combined return and risk of each portfolio.

The steeper the gradient, the higher the Sharpe Ratio the better the combined performance of risk and return."

"Ideally if investors are risk averse they should be looking for high return and low variability of return; in other words, A, A', A".

"However, like any mathematical model it relies on the data being correct."

"Expected Returns' is an easy term to define; but, the quantification of the concept is nothing more than one's own assessment of what an investment's expected return might be compared to other investments."

  • If Sharpe or anyone else could actually predict 'Expected Returns,' they would not be spending their time with dalliances and frivolities like Sharpe Ratio type contrivances.
    • They would have been investing and currently would control most of the money in the world.

"Pyramid schemes with a long duration of operation would typically provide a high Sharpe Ratio when derived from reported returns but the inputs are false."

"Investors are often advised to pick investments with high Sharpe Ratios."

  • Oh really?
    • investments that offer the best return with the least investment risk within the investing constraints of an investor's investment profile?
      • Wow, brilliant!

The problem with Sharpe Ratio analysis is not the concept; it has been verbalized since investing began and everyone in the world would agree with..... 'Ideally if investors are risk averse they should be looking for high return and low variability of return.'

The problem is finding Sharpe Ratio, higher expected return, lower risk investments:
  • Current and future behaviors, returns, and risks of investments and the financial markets cannot be predicted mathematically; especially when the origins of the numbers applied come from databases of past investment performance.
  • Variability (and volatility) are neither measures of nor predictors of investment risk.
    • Many low variability, low volatility investments have collapsed (GM) and many high variability, high volatility investments have flourished (GOOG).

The point being, when categorizing, ranking, and selecting investments for investor A and investor B above using Expected Returns and Beta, for example, the investments selected to match each investor's investment profile will generate performance result no better than random investment selection.

So, why waste the time deluding yourself that Sharpe Ratio analysis will help you sort and select investments investments for investor A and investor B!

Investing Risks

Effective investment risk measurement and investment management must focus on the elements that actually cause and the actually affect investment and investing risks and returns; investment and investing judgment and investing by taking into consideration the actual investment/investing variable connections rather than by perceived investment/investing variable coincidences.

The actual amount of investment and investing risks can best be determined by the presence of or the lack of consideration and application of the following actual — verses theoretical — investment and investing risk management variables; the more, the less the investment and investing risks, the fewer, the greater the investment and investing risks:

Systemic Risk

  • Systemic risk is the risk of collapse of an entire financial system or entire market, as opposed to risk associated with any one individual entity, group or component of a system.
Specific Risk
  • Risk that affects a very small number of assets. This is sometimes referred to as "unsystematic risk."
Structural Risk
  • Risk of an investment because of its structure; government insured bond vs. options.

Fundamental Risk

  • Risk of an investment based on its intrinsic value by examining related economic, financial and other qualitative and quantitative factors.

Timing Risk

  • Risk that the investment was bought at the right time, held for the right time, and sold at the right time.
Management Risk
  • Investment selection, investment timing, and portfolio management skills of the investing decision maker.

Management Risk In Greater Detail

Actual investment and investing risks and the probabilities of investment and investing success are the risks and the probabilities directly and solely related to whether or not an investment advisor knows what he or she is doing, their level of investing judgment, the degree investing of skills he or she has in applying that knowledge to investing, the investment strategy used, what is bought/sold, how much is bought/sold, when it is bought/sold, and for how long it is held.

Absent these considerations, all investments, regardless of the type, and the processes of investing are risky if put into the wrong investment management hands:

  • Investment Quality
    • Mature, established, emerging, unproven companies.
  • Capital Allocation
    • Distribute capital to different investment sectors that have separate and distinct investment characteristics and that tend to behave differently as the financial markets change; cash, bonds, REITs, large capitalization equities, etc.
    • Distribute capital to many, several, a few, or single investment sectors.
  • Investment Diversification
    • Many or a few investments in an investment sector.
    • Equal or unequal investment weighting for each investment within an investment sector.
  • Investment Structure
    • Debt and/or Equity; lender and/or owner.
    • Equity and/or Derivatives; shareholder and/or gambler.
    • Bonds; secured and/or unsecured, insured and/or not insured, investment grade and/or junk.
    • REITs; equity and/or mortgage.
  • Portfolio Management
    • Diversification.
    • Rebalance.
    • Reallocate.
  • Price Management
    • Lump-sum purchase and/or dollar-cost-averaging.
    • Predetermined price limits to buy/accumulate and to sell/distribute.
  • Portfolio Management Disciplines, Rules, and Procedures
    • Global
      • Investing Principles and Perspectives — Who you are, what you represent, how you conduct your business; what you need to know, do, have, use, and avoid to invest successfully; what, when, why, how, and what if..
      • Investment Selection Disciplines, Rules, and Procedures; for example, "A Simple Bond Plan".pdf
      • Investment Sectors — User adds to fit investment philosophy and style; such as categorized by broad investment classes such as bonds, equities, mutual funds, money managers, and user defined or by different economic or business investment sectors.
      • Investment Categories — As a subheading to Investment Sectors, user adds to fit investment philosophy and style; such as to categorize by different economic/business sectors or by specific types of bonds, mutual funds, money managers, and user defined investments.
      • Investment Quality — Match to investor's investment risk profile.
      • Investment Database — Potential and recommended investments.
      • Asset Allocation Matrixes — A central investment theme and variations on that investment theme to generate different asset allocations for different types of investors.
      • Asset Allocation — Match investor investment objectives with the appropriate types and numbers of weighted investment sectors and weighted underlying investments.
      • Investment Diversification — Match investor investment comfort zones and time horizons with the appropriate types and numbers of investment sectors and underlying investments by investment categories.
      • Model Portfolios — Suitable, hopefully timely investment sectors and investments by investment categories for different investment strategies.
      • Cash Investment Portfolios — Create unique investment portfolios that match investors with the correct investments.
      • Blended Investment Portfolios — Blend an investor's existing investments with a model portfolio to the extent and when desired to bring new investors under one investment umbrella and to update existing client's portfolios with current investments as opposed to having too many different investment portfolios and to many different investments in different investment portfolios that were intended for the same or outdated objective.
      • Rebalance Portfolios — Reset investment portfolios to original investment sector and investment weightings to maintain the initial structural integrity of investment portfolios.
    • Personal
      • The Investment Past — Other than in passing, other than a reference point is irrelevant.
      • Protect Capital — Regardless of the market conditions, always be in the investment present, on the investment defensive, and never excuse present portfolio cash value with future value hopes, explanations, and expectations.
      • Primary Investments — Cash, bonds, equities, and real estate — Packaged products are never better than the investment integrity of the underlying investments.
      • Interest Income & Dividends — All portfolios.
      • Trading — Never, unless the client knows at least as much as I do.
      • Alternative Asset Class Investments such as Hedge Funds, Private Equity, and Limited Partnerships — Often have lock-up provisions and other limitations on liquidity, difficult to value/price, no investment so good that it is worth losing liquidity.
      • Liquidity — Must be a daily market, never sacrifice for apparent investment opportunity.
      • Commodities — At no time to speculate, OK to hedge, and never unless the client knows more than I do.
      • Money Managers & Mutual Funds — Second choice. Why have them do what I am supposed to be able to do.
      • Bond Mutual Funds — Never. There is always a better, smarter way.
      • Investment Firms' IPOs — In most cases, if you can get it, you do not want it.
      • Modern Portfolio Theory — Investment diversion amusement.
      • Companies — Quality, products, management, competitive, balance sheet, accounting, earnings, growth, research and development, entry, and use of debt. 
      • Earnings — Realistic, maintainable, accurate, honest, and increasing.
      • Margin* — Never leverage capital to buy more investments unless borrowed capital will be used only as a short-term source for cash needs outside the investment portfolio and where there is a clear and specific source of funds to eliminate margin in the short term.
      • Sell Short* — If Warren Buffett can survive without shorting stocks, so can I; odds are bad going against the upward bias of the market, loss potential infinite.
      • Options* — Never buy, never write covered, and never, ever naked. Well, OK, maybe "buy" every once-in-a-while!

Find skilled investing management that can find suitable investments and place them in structurally and fundamentally sound investment portfolios, do your best to buy and sell investments at the right time (difficult to do does not translate into therefore don't try), and govern with investment selection and portfolio management disciplines, rules, and procedures and all other 'imagineered' investment selection conceptual contrivances and risk measurements fall by the wayside and I can tell you exactly what your investing, investment, and portfolio risks are; very close to, if not zero.