When you look up an investment, often it’s published with the six risk statistics: Alpha, Beta, Mean Annual Return (or just “Mean”), Standard Deviation, Sharpe Ratio, and R-Squared. It’s important to look at both performance and risk. If you see an investment that outperformed the S&P 500, it can be easy to get excited, but a quick look at some of these risk ratios can tell you perhaps why it happened. Let’s go through the six ratios and I’ll show you some of examples of how to use them along the way.
Alpha – My nickname for this ratio is “the beating the system ratio”. It tells us when recent past performance has been better than you would expect for an investment’s risk level. Let’s say you have an investment and other similar investments got 10% and your investment got 12% then it’s going to give you a higher Alpha number (2.0 in this case). This is the same with conservative investments. It’s meant to show relative performance over its peers. If Alpha is “0” then it means that your performance was exactly what you’d expect based on the risk level of your investment. You want Alpha to be above “0” as it means that you “beat the system” and got more return that you’d expect with your risk level. If alpha is negative it means you got less return than you should have for your risk level. If you see an alpha of 3.17 it means that it outperformed its relative benchmark by 3.17% Keep in mind that alpha doesn’t tell you whether or not you lost money or made money, just how you did relative to your risk level.
Beta – This tells us how much your investment correlates to the stock market. In an investment has a Beta of 1.0 then if the market goes up by 10% then your investment went up by 10%; conversely if it went down by 10% then you went down 10% – your investment is correlating perfect with the stock market. If you’re looking at something with a Beta of higher than 1.0 then you should expect more volatility in it. If the Beta is 1.7 then if the market goes down 10% you would expect to go down 17%. Beta’s can also be negative such as with some US Treasury investments; it means that if stocks go down, then you go up. When you see the term Beta, you can think “volatility”, but more specifically “correlation to the market”.
Mean Annual Return (or just “Mean”) – This is the simple mathematical average of a set of numbers. A point of emphasis is that there’s much more to look at than average returns. Let’s say that you’re looking at an investment that had an average return of 10% over the past five years. One investment could have done that with these results: 10%, 10%, 10%, 10%, 10% or another could have done it with: 50%, -40%, -30%, 40%, 30% (we’re using rough math here). It’s just an average, but lacks in telling you how they got there and whether it was a bumpy path or not. Because of this, strictly speaking, “mean” is not truly a risk statistic.
Standard Deviation – Just to state it, this measures the dispersion of data from its mean. The way I explain it is weather. Hawaii is known for its consistent temperatures. 80 degrees in January, 88 degrees in July. The mean temperature would then be 84 and in this case the Standard Deviation would be very low because there is not a very wide dispersion of data. If I had a secret envelope and you had to guess what temperature it was on that day in Hawaii you’d have a decent shot at it by guessing a number in the 80s; hence the data is predicable. It’s the idea of knowing an average (or more specifically the mean) and knowing how certain you are that it will keep happening. Conversely, I’ll use my home city Denver, CO. We have famously volatile weather. The coldest I remember is -15 degrees and the hottest is 105 degrees. So you could have a mean temperature of 60 degrees, but it’s a far wider dispersion of data from this mean. Again, if I had a secret envelope with a date on it, it’d be much less likely that you’d guess the correct temperature on that date. With investing it’s the same concept. Something may have a mean annual return of 10%, but it could mean that last year it got 20% and the year before that -30% and the year before that 40% and the year before that -20%. This high volatility would give you a higher Standard Deviation. In a perfect world, you’d find an investment with a satisfactory mean return and a low Standard Deviation meaning you are more likely to count on that return like you could count on good weather in Hawaii.
Sharpe Ratio – This is calculated by subtracting the risk-free rate of return (US Treasury bond) from the rate of return of an investment and then dividing the result by the investment’s standard deviation. It’s seeking to mix a lot of these things together and tell investors whether or not an investment’s returns are due to smart investment management or due to excessive risk. Case in point, if everything is going well in the capital markets then usually the riskier investments do better than the less risky investments, so how do you compare these two? This is what the Sharpe Ratio seeks to do, and the higher the better for this number.
R-Squared – This is a way to spot investments that don’t have much unique management. It’s a rating from 0-100. If the R-Squared is 100 it means that its price moves track exactly with the index. If the investment claims only to try to track with the index then you’re getting what you want. However, if an investment claims to be doing something unique though fancy stock picking but it’s R-Squared is close to 100 then it suggests to you that there isn’t much unique investment management to it and that maybe it’s not being actively managed as it could be.
It’s best to look at the ratios relative to their category and to look at them over a 3 year, 5 year and 10 year period to get the best sense of it. We live in unprecedented volatile times and it’s really do a number when you look at an investment’s risk ratios; it’s best to get a broad picture before making a decision.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.