How to maximize profit at lower risk
Market wisdom tells us that if you want to achieve a higher return on your investments, you must be ready to assume a higher risk and tolerate the possibility of higher losses.
Last week, I explained in the column “How to profit with market volatility” that taking a calculated risk could help control losses and increase the chances of winning.
Because risk is typically associated with volatility, one way to estimate the volatility of a stock is by computing the standard deviation of its historical returns.
Once the volatility of stocks is identified, depending on your risk tolerance, you can create a portfolio of high risk and low risk stocks to suit your investment objectives.
As an investor, you want to have an investment portfolio that can generate good returns at the lowest possible risk.
But how do you maximize the potential returns of your portfolio while reducing the overall risk?
One metric you can use to measure the performance of an investment is called the Sharpe ratio.
This ratio, which was developed by Nobel laureate William Sharpe in 1966, is calculated by taking the excess return of an investment over the risk-free rate and dividing it by its standard deviation.
To illustrate, let’s say you have three stocks in your portfolio that are equally allocated, namely, San Miguel Corp., which has a five-year historical average return of +20 percent; BDO, +10.7 percent; and D&L Industries, +24 percent.
As a portfolio, the average expected return of the three stocks is computed at 18.5 percent with standard deviation of 28 percent.
To get the excess return of the portfolio, we deduct the five-year Philippine bond yield as “risk-free rate” of 5.5 percent from the expected return to derive 13 percent.
Dividing this by the portfolio’s volatility of 28 percent, we calculate a Sharpe ratio of 0.46. This means that for every 1 percent of risk that the portfolio assumes, the excess return is only 0.46 percent.
By standard, a Sharpe ratio of less than 1.0 is not good. A better ratio will be somewhere between 1.0 and 2.0, while a very good one will be a ratio that is above 2.0.
You can compare how your investment is performing by comparing its Sharpe ratio with other portfolios.
If there is a mutual fund that generates a similar return of 18.5 percent but has higher Sharpe ratio than yours, you may be taking unnecessary extra risk to produce the same return.
If you want to improve your Sharpe ratio, you can simply add more stocks that generate higher expected returns at comparable risks.
Let’s add three more stocks into the portfolio, namely, SM Prime, Wilcon Depot and Ayala Land Logistics, that have a combined average return of 46 percent with 26 percent standard deviation.
By adding more stocks, the average expected return of your portfolio improves to 32 percent from 18.5 percent, while volatility decreases from 28 percent to 24 percent.
With a higher return and lower risk, your Sharpe ratio goes up to an acceptable level of 1.14 from 0.46. If you double your allocation for the additional stocks, you can further improve your Sharpe ratio to 1.3.
Interestingly, if we treat the PSE index as a portfolio, using a 10-year average return of 21.7 percent at 41 percent standard deviation, we will get a Sharpe ratio of only 0.53.
If we use a shorter timeframe of five years, the standard deviation will be lower at 21 percent, but the average annual returns will also be lower at 5.17 percent, which is lower than current bond yield of 5.5 percent, resulting in negative Sharpe ratio.
Based on these results, perhaps, it may not be a good idea to create a portfolio that simply follows the PSE index. You need to add other promising stocks with similar risks to generate excess returns.
While using Sharpe ratio can be a useful tool in managing risk and return trade-off, take note that the ratio relies on historical average returns, which may not become actual returns in the future.
