Since 1998, the US stock market has not delivered any returns for an investor who bought and held over that period. In fact the S&P 500 today is exactly where it was at the end of 1999. We have seen many years of bull runs over the last decade, but those gains have been negated by severe bear markets as well. Even the stock markets of Asia, after an impressive bull run from 2002 to 2008, have not delivered any steady gains for the buy and hold investor. And even commodities like oil, wheat, copper have not provided steady returns for any extended period of time over the past 4 years. The only exception so far has been gold. But even gold has been stuck in a rut since the middle of 2011.
During this period, several mutual fund as well as hedge fund managers have marketed themselves as sources of steady returns or having beaten the market. But how is an investor to judge whether they are being amply compensated for the risk being taken by these money managers. A lot of money managers will beat the market over a short period of time, but it is important to know when a particular strategy is starting to lose its luster. I am a firm believer that "buy and hold" does not work, whether it is a stock, a strategy or even a hedge fund investment. You have to be able to judge the viability of each investment in a particular market environment and be ready to change your portfolio allocations accordingly.
The most common way to do this is to look at not the returns, but the risk adjusted returns. In this article I will discuss some of the commonly used risk measures by the financial industry as well as some of the measures I have used when hiring and rewarding traders at banks as well as for my hedge fund.
The Sharpe ratio is the most commonly used method of adjusting the returns by the risk taken in generating those returns.
Sharpe Ratio = (Annualized Returns - Risk Free Rate)
(Annualized Volatility of the Returns)
The first step is to subtract the returns that could be obtained by simply putting your money in US Treasuries. The next step is to divide the left over returns by the volatility of those returns. The best way to calculate the volatility is to use the STDEV function in Excel. And finally, to annualize the volatility, multiply the result of STDEV by 16 if you are using daily returns.
Example: Annualized Returns = 10%
Risk Free Rate = 1%
STDEV (Daily Returns) = 1%
Annualized Volatility = 1%*16 = 16%
Therefore, Sharpe Ratio = (10% - 1%) / 16% = 0.56.
Generally, a Sharpe ratio greater than 1 is a good risk adjusted return.
The Sortino ratio is a variation of the Sharpe ratio, where it only looks at the volatility of the days when the returns were negative. This ratio does not penalize the strategy for producing outsized positive return days.
Sortino Ratio = (Annualized Returns - Risk Free Rate)
(Annualized Downside Volatility of the Returns)
To calculate the downside volatility, just take the STDEV of the negative returns and multiply by 16 if taking the daily returns.
The Sortino ratio will be greater than the Sharpe ratio, as it eliminates the volatility of the positive days. Generally, I would look for a Sortino ratio greater than 2 for an investment strategy.
And now here are a couple of risk measures I particularly like to use when judging an investment strategy:
RMD Ratio = Net Returns
This is a direct measure of the returns versus the maximum pain taken on holding that particular investment strategy. In my opinion this is a more practical way of looking at risk adjusted returns. The maximum drawdown is the maximum loss from the peak to the trough. Consider the following example:
Day Cumulative Returns
In the above example, the maximum drawdown was 2.4% between day 5 and day 7.
Therefore, the RMD Ratio = 3% / 2.4% = 1.25.
In the above example, I have calculated this ratio over 9 days, but in reality I like to look at this ratio over a whole year and for every single year of that investment strategy's life. This tells me how well the strategy is able to cope under different market conditions and also if it is maintaining its edge or whether it is starting to lose its luster.
As a money manager who is trying to produce absolute returns, i.e. positive returns every single year, another very simple measure I use is to see if a particular strategy produces positive returns every single year. I use the calendar year for the sake of simplicity. This is also a good measure of consistency and good risk discipline. The strategy does not have to hit the ball out of the park every single year, but positive returns every single year is something I can definitely position in my portfolio.
An investor might wonder what the benefits are of looking at risk adjusted returns from a practical standpoint. There are two major benefits:
1. Risk Discipline
Every prudent investor and trader's number one concern should be to not lose their shirt on a single trade or a single strategy. By looking at the above mentioned risk ratios, you can judge if the reward is large enough to justify the risk.
2. Ability to Leverage
If a particular strategy has a low MDD (maximum drawdown) then an investor can utilize leverage to magnify their returns. The rule I generally use is that if the historical MDD of a strategy has been 10%, I will multiply it by 2 and give myself an error margin and put my maximum potential leverage at 5 (100% / 20%).
Leverage is a double edged sword that cuts both ways and should be utilized very judiciously and in my opinion the individual investor should defer to a professional risk manager for those decisions.