How to Choose a Stock: Sharpe Ratio

Photo by Sigmund on Unsplash

There are some lessons from my father that I have always been keen on following, from being calm and patient, smart to being kind and valuing the smallest of things given to us in life. Even when it comes to investments it is my dad that I reach out to first. However, of all the advice he has ever given me I’m always perplexed of his advice to prefer long term investments over short-term. Now, see ever since childhood I have been taught that investments into stock markets or mutual funds/SIPs are the works of devils and people often get lost or tend to loose large sums of money all at once. I remember, watching a lot of television adverts back in the day, that had disclaimers like:

Mutual Funds are subject to market risk please read all scheme related documents carefully

Futures, stocks and options trading involves substantial risk of loss and is not suitable for every investor

The valuation of futures, stocks and options may fluctuate, and, as a result, clients may lose more than their original investment.

In fact, I am well aware that advertisements of such form still do exist today. However, like any other unsettling teenager, I too was curious whether this claim was right or wrong. Right after graduating from High School, I was given a small sum of money to keep, for when in need, by my parents. And again like any other unsettling teenager, I did not keep the money as a safety. Part of it was spent watching movies and buying cola cans (not a Pepsi fan), and the other half was spent buying some units into a risky mutual fund. The first few weeks were exciting: calculating my future returns, looking at the trends in the graph, oh it was as thrilling as skydiving from the top of the Burj Khalifa, and no I haven’t done that. However, in the weeks to continue I started to lose a lot of money, and even though the graph showed a positive trend things just didn’t work out. Back then I was as confused as any other newbie to investing, but I didn’t give up hope, and my days of spending hours on google, just googling investment basics had begun. This is when I learned about the Sharpe Ratio.

Now for a layman, an investment may make sense if we expect it to return more money than it costs right? (rhetorical question, don’t have to answer that). But returns are only part of the story because they’re risky and just like dice they may have a range of possible outcomes. Let me ask you another question, not a rhetorical one this time: Let us say you have 2 stocks A and B that may deliver the same result on average but exhibit different levels of risk, how would you compare them? This is where the Sharpe ratio comes into play.

Simply put the Sharpe ratio:

measures the risk to return of a given portfolio

and one can measure it using the given formula:

For some of you whom may not know, risk free rate of return is the amount of return you would expect out of a portfolio if it had zero risk.

Your Next Steps

If you have a large index of stocks to choose from you can calculate the sharpe ratio for each and consider referring or plotting a efficient portfolio graph as the one shown below:

Efficient Portfolio Curve by moneychimp

This is simply a graph of volatility vs return. The curve here is the Sharpe ratio which can be calculated using the formula above. The tangential line to the curve is known as the capital market line. The CML represents those portfolios that optimally combine risk and return. Now, the point ‘x should be your main focus as an investor. This point is the intersection between the 2 graphs and it is the most optimal portfolio which gives you the most return on each unit of risk. Hence, go for any portfolio that is closest to the ratio that x poses.

Conclusion

Let us now get back to the same question I had asked before, ‘Let us say you have 2 stocks A and B that may deliver the same result on average but exhibit different levels of risk, how would you compare them? ‘ You now have an answer to this question: the stock with the higher Sharpe ratio is the one you should prefer as it gives more return per unit risk.