Investors will take risk if they expect it to be rewarded, so certain reward-to-risk ratios have been developed like the Sharpe and Sortino ratios. The Sharpe ratio views risk as total return volatility. By contrast, the Sortino ratio uses downside risk, defined as the standard deviation of returns below your Essential Return Objective (ERO). The ERO is the return you need to earn in order to achieve your objective.
Dr Sortino is a pioneer in management to objectives who created Post-Modern Portfolio Theory (PMPT). To examine the risk-reward tradeoff he measures upside standard deviation above your ERO and compares it to downside risk. Ideally you want upside potential to exceed downside risk, indicating that the risk is worth taking. Normally, upside potential exceeds downside, but that is not true today if your ERO is fairly high, as shown in the following picture:
In a nutshell, unless you plan to be conservative, the downside outweighs the upside – not a good bet. This doesn’t mean that risk won’t be rewarded, but the pursuit of the reward carries more risk than is usual, primarily because asset prices are high.
If you’ve been thinking about reducing risk, this analysis supports that move. You can move to a more conservative allocation where downside risk is less than upside. In other words, move to where risk is more likely to be rewarded.
Another choice would be to consider active managers. The results above are based entirely on passive implementation of asset allocations. Active managers might add enough value to restore the upside/downside ratio to above 1, but of course there are no guarantees.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am a sub-advisor of the SMART TDF Index and the originator of the 1st and only Robo Analyst that integrates Age with Risk. Please visit my Blog at seekingalpha.com/...
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