How to Measure Risk and Reward in the Market

penny stocks

It might be an obvious statement to say that the goal of investing is to generate profit, but that’s not to say that all profits are created equal. Basing a successful strategy off the basis of total returns alone isn’t a valid methodology. There needs to be an accountability of risks taken to achieve the results in order to determine if the strategy is good for long term success or simply a one-off fluke.

A portfolio invested solely in commodity futures could achieve staggering gains compared to a diverse stock portfolio, but it also takes on far more risk. The former commodity futures portfolio could just as easily experience extremely high losses, whereas a more diversified stock portfolio wouldn’t have those kinds of large swings. In the end, there needs to be a balance between the amount of risk taken on and the estimated returns your portfolio should achieve.

The balancing act

Let’s say we’re comparing two portfolios in order to see which one is better. Portfolio A posted a return of 20 percent, while portfolio B only posted a 10 percent gain. At first glance, it seems easy to say that portfolio A is the better choice, but there’s not enough information available to be certain just yet.

Going a little deeper, we see that portfolio A was invested in speculative small cap stocks, while portfolio B was invested in large cap value stocks. Furthermore, we discover that both portfolios could have lost just as much as they gained, meaning that portfolio A could have had a 20 percent loss instead of a 20 percent gain.

In order to truly measure a portfolio’s total performance, we need a way to include assumed risk. Ratio’s like the Sharpe ratio, M squared, and the Treynor ratio can help break down a portfolio to more easily judge which is a better fit.

The Sharpe Ratio, or reward-to-variability ratio

Sharpe ratio = (Rp-Rf)/Std

Rp = Mean return of portfolio being evaluated

Rf = Risk-free rate

Std = Standard deviation of portfolio being evaluated.

This ratio can be used to determine if a selected portfolio has beaten the market or underperformed relative to risk. Assuming risks are equal, the higher ratio indicated the better portfolio.

M Squared Ratio

M squared = Rp – Rm

Rp = Risk-adjusted rate of return created through a combination of a portfolio and a risk free asset

Rm = Return of the market portfolio

M squared is used similarly to the Sharpe ratio to compare risk-adjusted returns between two portfolios. A positive M squared means the portfolio outperformed the market, while a negative one means the market was the better portfolio.

Treynor Ratio, or reward-to-volatility ratio

Treynor ratio = (Rp – Rf)/B

Rp = Mean return of portfolio being evaluated

Rf = Risk-free rate

B = Beta of portfolio being evaluated

The Treynor ratio helps investors determine which portfolio is taking on more risk. Figures greater than one mean more risk in being taken than the market portfolio. While that might seem like a bad thing, if expected returns are equally higher, it would be equal to the market.

Investors should take into account the type of assets involved and risk being taken before committing to a portfolio. High risk generally means higher reward, but it might not be equal. Ten percent more risk might only translate to a 1 percent higher gain, making it less desirable than the market average. Using risk ratios, investors can analyze different possibilities effectively before investing.