How To Use Two Little Known Investment Ratios That The Pros Use

The Sharpe Ratio and Information Ration are two popular investment rations investment advisors use to assess risk in stock and other equity investments.

The Sharpe ratio compares the profit in excess of the T-Bill rate of return, divided by standard deviation. By contrast, the Information ratio uses a more relevant benchmark than Treasuries. For the Information ratio is calculated by taking the excess return of an investment over a similar index and then divides the result by the investment’s standard deviation. So the IR is more sophisticated and relevant than the Sharpe, especially when T-Bills are at artificially low rate. Both ratios are attempting measure the ratio of risk to return. This is just as important as measuring the inflation adjusted or tax-adjusted rate of return.

Why does the Sharpe ratio show lower results than the Information ratio? This is because currently bonds have been doing better than stocks on a risk adjusted basis over the past 3, 5, 10 years. Sharpe ratio uses T-Bills as a benchmark. IR uses stocks as a benchmark for stocks, so if all stocks go down together this camouflages the damage done. Of course, when T-Bills are artificially low then that creates some statistical anomalies. Basically, never rely on just a few quantitative tools; use many different types of tools and try to understand the qualitative reasoning as to what they are trying to tell you and then ask yourself if this current environment has made some of the models dysfunctional – always do your thinking for yourself – never let a machine, formula or another person do your thinking for you.

This is independent investment advice. Remember to not only be independent of commission driven “sell-side” advisors, but also be independent of non-thinking machine-driven formulas, and independent of group-think mass hysteria, etc.

About the author

Don Martin, CFP®


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