Enjoy Better Risk Adjusted Returns: The Sharpe Way to Manage Your Money
Updated: Jul 30, 2021
You want stocks for growth, but you need bonds for stability.
No matter your Stock-Style, your Bond-Layer provides portfolio stability. Cryptocurrency, options and stock trading can produce spectacular gains with significant risk. For every YOLO success story, there are probably 10, 100 or even 1,000 YOLO fails. However, one thing is universal any good investment approach has more than one asset class.
Improving risk-adjusted returns is why you own bonds.
Investors must diversify! “Don’t put all of your eggs in one basket.”
Make sure all your eggs aren’t the same; diversify across asset classes.
Growth and stability are complementary over the long-term.
Professional investors are always looking for ways to either increase return or decrease the volatility of their investments. The Sharpe Ratio is one of the most important tools used by professionals to measure risk-adjusted returns.
Investors use the Sharpe Ratio to compare different portfolios in order to make judgements about the soundness of an investment. Two similar portfolios where one has a higher Sharpe Ratio than another means that it has higher returns per unit of volatility and is the better choice.
In the table below we compare a 100% stock portfolio with a 60% Stock/ 40% Bond portfolio. From the results we can see that while the Compound Annual Growth Rate (CAGR) declines 18% from 10.42% to 8.58%, the Standard Deviation (Stdev, or volatility) dropped by a whopping 40%. This means that although the performance might be slightly lower than the all-stock portfolio, the risk has been drastically reduced.
This is because the bonds have better risk adjusted returns (Sharpe Ratio 0.78) and dramatically superior downside protection (Sortino 1.29).
At Arthur, we want to offer tools to help you plan your portfolio in the most optimal way. So you can earn the high returns of higher risk assets, but we want to offer you the ability to have a more thoughtful approach in investing.
History may not predict the future, but it definitely does rhyme.
In the table above stocks have the highest Compounded Annual Growth Rate (CAGR), but look at the Max Drawdown and Worst Year for stocks compared to bonds. WOW! Sharpe and Sortino are two commonly referenced ratios that can be used to compare risk-adjusted returns.
William Sharpe and Frank Sortino discovered the benchmark risk-normalization ratios that bare their names. The summary presented in the table above reflects 30-years of actual financial market data and the evidence is irrefutable:
Balanced portfolios have better risk adjusted returns than 100% stock portfolios.
This holds true regardless of how you choose to manage your Stock-Layer.
Clearly you are interested in optimizing the performance of your investments and you're on top of your stock portfolio. However, is it possible that you are neglecting your bond-layer?
Maybe you own no bonds, or perhaps you simply index. Maybe you're holding excessive amounts of cash or paying a bond mutual fund 20% of your expected profit. The point is you can do better than you are doing using the limited tools that are currently available to you. Don't resort to savings accounts, low-yielding government bonds, money markets or other pooled investment schemes; you just need to do a little bit of learning and tending to your bond-layer.
The next 30-years starts today! Do you even have any bonds?
How sure you are about any one of your given investments? Are you 50%, 100%, or 1,000% sure that nothing can go wrong? The first rule of life isn't YOLO, it is, "there ain’t no such thing as a free lunch." Diversification, however, is the free lunch in investing. Diversification is like your car insurance; when you have it and you're not in an accident, you think it's a waste of money. But when you get into an accident, you thank your lucky stars that you have that insurance. Diversification works the same way and risky strategies eventually have accidents.
Analysts often use correlation to guide their diversification decisions. Correlation is a statistical measure of how two different types of assets move in relation to each other. For example, if stocks tend to rise when the economy is doing well and bonds tend to rise when the economy is doing poorly, then a balanced portfolio of stocks and bonds will experience less volatility (ups and downs) in their performance.
Just because two assets aren’t correlated doesn't mean that they don’t sometimes move in the same direction. In fact, almost any two assets have some degree of correlation. The trick is to find assets that are uncorrelated, or at least have a correlation that is low enough to make diversification worthwhile.
If you currently feel that you want to learn more about bonds, or even, "bank some tendies" , but don't know where to start; we are building a new bond community called Arthur. The need for bonds is universal and Arthur will provide easy and equal access to the institutional bond market regardless of your account size.
Investors who are capable of managing their own stock, crypto and alternative portfolios, certainly don't need to pay 20% of their bond returns to some Bond King. We say, "Nay Nay, we demand equal access!" We are all capable of buying our own bonds and enjoying the smoother performance of a balanced approach to investing.