If you're choosing investments based on total returns over specific
time periods (i.e., 1yr, 3yrs, 5yrs, and 10yrs) without assessing
the risk, it's time to add another component to your selection
process.
Laptop Battery Standard Deviation and the Sharpe Ratio are two basic tools that
are used by investment professionals for determining risk and, with
a little practice, you can be using them too.
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Thinkpad Although standard deviation isn't limited to the area of
investments, it is a measurement of volatility that translates into
risk. High standard deviations denote a wide range of investment
returns and low deviations denote a narrow range of returns.
After training, he finds the stocks that yield good out of sample returns, high Sharpe Ratio, linear equity curve as well as other informative statistics related to the model.
Microsoft A word of caution: standard deviation won't do you much good
unless you're using it to compare standard deviations among other
like investments. Taking things a step further, if you compare the
standard deviation to a benchmark (i.e. an indices standard
deviation), you can see how closely those investments are
performing to their benchmark on a risk adjusted basis.
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Laptop Computers Now for the fun part. Let's compute some standard deviations
using hypothetical investments:
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Laptop Computer Assume Large Cap Investment A has a 9% average return over a
three year period (the most common time frame for measuring
standard deviation). Assume, also, that it has a standard deviation
of 6.
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Desktop Computer Now also assume that Large Cap Investment B has an average
return of 9% over the same three-year period, but that it has a
standard deviation of 7.
Notebooks To find the range of returns for either of our hypothetical
investments, you need to take the average rate of return and add
(or subtract) the standard deviation for that investment. The
result will give you the range of returns for that investment 68%
of the time.
Lenovo In our hypothetical example above, while both investments have a
9% average return, Investment A has a range of returns from 3% to
15%. Investment B has a range of returns from 2% to 16%. Because
Investment B has a wider range of returns, it would be deemed to be
the more volatile (or riskier) of the two investments.
Hard Drive Now let's look at a hypothetical benchmark to compare these
investments. Let's assume that the benchmark return for Large Cap
Investments is 7.25%, with a standard deviation of 5.5. Using the
above formula, the benchmark range of returns for Large Cap
Investments would be 1.75% (7.25% minus 5.5) to 12.75% (7.25% plus
5.5).
Travelstar So far so good, but now how do we compare Investment A (with a
9% average return and a standard deviation of 6) to the benchmark
(with a 7.25% average return and a standard deviation of 5.5)? For
that we turn to the Sharpe Ratio.
Gateway Developed by Bill Sharpe, the Sharpe Ratio attempts to quantify
an investment's risk relative to its investment performance. The
higher the ratio, the better the investment's performance after
adjusting for its risk.
Laptop Parts Our formula takes the difference between the return on a
particular investment and the return on a risk-free investment.
That difference is then divided by our standard deviation. That
should give us our answer.
Software Although no investment is truly risk free, let's use a low-risk,
90-day Treasury Bill, with an average return of 2%.
Hard Drives Our Sharpe Ratio for Investment A would be as follows:
Electronics 9 (Investment A's average return) minus 2 (T Bill's average
return) = 7 (Excess return over a risk-free investment)
Canon 7 (Excess return over a risk-free investment) divided by 6
(Investment A's standard deviation) = 1.67 (Sharpe Ratio) Our
Sharpe Ratio for the Benchmark would be as follows:
Desktop Pc 7.25 (Benchmark's average return) minus 2 (T Bill's average
return) = 5.25 (Excess return over risk free)
Desktop Computers 5.25 divided by 5.5 (Benchmark's standard deviation) = .95
(Sharpe Ratio) Because Investment A has a higher Sharpe Ratio
(1.67) than the benchmark (.95), it is deemed to have a better risk
adjusted return.
Think Pad If you want more information on standard deviation and the
sharpe ratio, there are several sites on the internet that will be
happy to accomodate you.
Repair Remember, these are only two tools used in the process of
selecting securities. They are not infallible, but they can be of
tremendous help in keeping your portfolio in top-notch shape.
Data Recovery Glenn ("Chip") Dahlke, a senior contributor to the Living Trust
Network, has 28 years in the investment business. He is a
Registered Representative of Linsco/Private Ledger and a principal
with Dahlke Financial Group. He is licensed to transact securities
with persons who are residents of the following states: CA. CT, FL,
GA, IL. MA, MD. ME, MI. NC, NH, NJ, NY.OR, PA, RI, VA, VT, WY.
Cisco If you have any questions or comments, Chip would love to hear
from you. You may contact him by email at
dahlkefinancial@sbcglobal.net. You may also contact him at the
Living Trust Network. Its web site is
http://www.livingtrustnetwork.com
Keyboard Copyright 2005. Living Trust Network, LLC. All Rights
Reserved.
Monitor Get a free list of internet sites that provide information on
standard deviation and the sharpe ratio - send the Living Trust
Network an email at cdahlke@livingtrustnetwork.com.
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