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Stay sharp with the Sharpe ratio

The rules and regulations relating to investments have changed considerably since 2002, especially in terms of advice given to clients.

In addition, we now find ourselves in the “calm before the storm” as investors are becoming increasingly worried about the market’s high and risky levels.

Many are either starting to flee or to search for tools to protect their investments, just in case a storm breaks. 

Risk-adjusted returns (RARs) are most certainly one of the best ways to protect investors.

The generally accepted standard is that as the expected returns on investments grow, the risks taken to achieve that growth also increase. The RAR shows the returns on an investment for every unit of risk taken. 

This ratio is a helpful tool to compare investments with one another, and to determine whether the returns on a specific fund are due to good investment decisions or due to additional risk taken. 

Clearly then, we should look at more than the historical returns on a specific asset class or investment (even though many “investment professionals” often do just that).

The RAR is better known as the Sharpe ratio and the calculation thereof is fairly simple: the risk-free rates are deducted from the fund’s rates and then divided by the fund’s volatility (standard deviation).

It is an excellent relative ratio and investors are simply to look for the investment with the highest ratio (highest return relative to the least risk or volatility).

A good example is when we compare the South African Equity General sector to the South African Multi Asset High Equity sector (which is limited to 75% exposure to shares). ?

For the more conservative investor, the volatility of shares may carry significant weight in the decision to seek potentially higher returns.

This article originally appeared in the 9 July 2015 edition of finweek. Buy and download the magazine here.

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