Hello.
I'm Brian Nick,
a strategist in our Chief Investment Office at UBS Wealth Management Americas.
Today I would like to talk to you about a concept I worked with everyday,
risk-adjusted return If you've watched my colleagues in prior videos you're
familiar with a few different definitions of risk.
To recap quickly the most common measure of risk in investing is standard
deviation.
Standard deviation tells us the range of terms in which investors can expect about
two thirds of observed returns to fall.
We say asset classes are risky when they have higher standard deviation.
And we expect those asset classes to deliver higher returns on average
than others that may have little to no market risk.
That brings us to the concept of risk adjusted return,
which allows us to compares apples to oranges in a sense.
By adjusting either historical or expected return on an asset class for
a degree of risk, we can compare, for instance, US treasuries,
to US equities when deciding how to invest.
If we were to invest solely based on maximizing return,
we would probably prefer US equities almost all the time.
But if our goal was to minimize risk, US treasuries seem the more prudent choice.
Risk-adjusted return allows us to combine these concepts, and
there are many ways to measure it.
Today I'll summarize just one example, the Sharpe ratio.
The Sharpe ratio measures units of expected excess return per
unit of volatility.
Excess return is simply the return we've received or expect to receive over and
above the risk free rate.
These days in most parts of the world this calculation is quite easy
because risk free rates are close to zero.
A high Sharpe ratio indicates a high risk adjusted return,
while a low Sharpe ratio indicates a low risk adjusted return.
I'll demonstrate how the calculation works by using the two asset
classes I mentioned earlier.
Let's say that US treasuries had given us a return of 3% with
a volatility of 5% while the risk free rate was 1%.
That would make the Sharpe ration 0.4- 2% divided by 5%.
Now let's say that US equities returned 14% with a volatility of 10%,
similar to their return in 2014.
That would give us a Sharpe ratio of 1.3, 13% divided by 10%.
1.3 beats 0.4.
In this example, equities have delivered a far superior risk adjusted return.
If only that were always the case, our job would be easy.
So why do risk of asset return matter?
Why wouldn't an investor prefer a return maximizing portfolio with 100% in
risky assets?
After all over time master strategy is performed very well.
But problem with this is most of us now is that very volatile investment strategies
are often difficult for investors to stick with when times get tough.
So including other asset classes with positive sharp ratios but
lower expected returns is optimal for nearly all investors.
By doing this we sacrifice higher returns for higher risk adjusted returns and
in all likelihood increase the probability we stick to our investment plans and
meet our financial goals.