The investing public in America has been relentlessly carpet-bombed with the stock investing mantra. Most financial advisors will repeat it for you: “Thou shalt heed that stocks are the best hedge against inflation, they may earneth thee 10% a year. Buy them ye must!”. And just like the Mormon Church, this is followed up with colorful marketing paper containing smiling pictures of financially secure people and their jubilant dogs.
I don’t say that one should shun the stock market. Far from it. But as we discussed in an earlier post, stocks are hardly a sure thing even over ten year periods.
This brings us to uncertainty, the inherent problem with investments. You know you are putting up money now, but what is going to come of it? This is the least desirable part of the investment process. We all want to make 10% a year without worrying about losing half the portfolio in some global crisis. Sadly, just like investors dream of returns without risk, teenage boys dream of a night out with Jessica Alba. Success rates are negligible.
However, hope springs eternal. Even institutional investors – seasoned executives responsible for billions – often expect to find Jessica Alba stuffed in a pot of gold at the end of the rainbow. “Where is Jessica?” say their hunted eyes, while I take them through the risks. Perhaps people have been overexposed to the bumper-sticker wisdom of Warren Buffet and Nassim Taleb. These two gentlemen between themselves have done a lot to confuse small investors. It’s not that they are wrong – it’s more like, well, when you are learning martial arts you don’t start by thinking you are Bruce Lee. Or in Taleb’s case, someone pretending to be Bruce Lee.
The Sharpe Ratio – what this article is about – is where the rubber hits the road. It tells you the balance between returns and risk.
Let’s say we agree that US stocks beat inflation by 6% or so over time – the so-called “real return”. But what is the uncertainty around that? The majority of the time, the market stays within 15% of its long term average. In other words, the lower handle is 6% – 15% = -9% and the upper handle is 6% + 15% = 21%. Let’s round that and say that the market returns between -10% and 20% in more than half (60% to be exact) of the years. So, 15% is a measure of the uncertainty in yearly market returns. We could even call it the “risk”.
This is not the only way of thinking about risk. But it is a pretty good way, even for long-term investors. I will show you in another post why that is, but for now let’s say this is a given.
So, this is the trade off : stocks give us 6% real return over time and we have to pay for that with 15% of uncertainty every year. Thus you have the Sharpe Ratio –
Sharpe Ratio for US Stock Market = 6%/15% = 0.4
Basically you get 0.4% of return for every 1% of uncertainty that you are willing to tolerate. The Sharpe Ratio is a Value of Risk.
It is named after William Sharpe who won the Nobel Prize for Economics in 1990. Not a bad deal- a Nobel for dividing two numbers! But there is a lot of difference between an investor who thinks only about returns and one who understands the trade-off with uncertainty. Investments with high Sharpe ratios typically have smaller drawdowns which is a huge virtue even if you consider yourself a very long-term investor. That is worth another post by itself (I promise).
We have discussed the Sharpe ratio for the total stock market thus far. What about the “Sharpes” of single stocks?
Here is a chart of real returns and risk numbers for some large companies across sectors. I have used data for the most recent ten years, 2005 to 2015.
Observe that the risk and return for S&P 500 came out close to what we thought it should be. The 5.4% from S&P 500 looks a bit mediocre, but the risk is low – only two individual stocks, Kimberly Clarke and Con Edison have lower risk numbers.
We can use the Sharpe Ratio equation to calculate the return/risk trade-off for each stock. Here is what that looks like:
The S&P 500 is doing better now. The Sharpe came slightly lower than the long-term expectation of 0.4, no doubt because of the Great Recession of 2008.
Let’s talk a bit about the three firms that had better sharpe ratios than the S&P. If you live in the New York tri-state area, you know that Con Edison is the local un-loved utilities provider. It is one of those bureaucratic firms that wouldn’t know innovation if it got slapped in the face with it. Curious indeed that it should have a good sharpe ratio.
You may also ask – “what the hell is Kimberly Clarke”? It’s a good question. I didn’t always know what KC was. And when I did come to know, I was in awe of the enormous boredom it represented. In off moments I have looked up names of analysts covering this company and speculated that surely one day, one of these individuals, is going to break down and shoot himself and we will have to read about it in the New York Post.
Like a lot of boring companies, KC is very useful. I have used KC’s products and most likely so have you. Do Kleenex tissues, Huggies diapers and Scott toilet paper ring a bell? Here’s a helpful graphic:
KC’s tireless focus on helping people wipe their behinds has paid off. The company is worth $50 billion, employs over forty thousand people and pays $1 billion in dividends every year.
Still, a Sharpe ratio that rivals the great Apple Inc? On one hand you have the genius of Steve Jobs. On the other, miles upon miles of toilet paper.
There is nothing co-incidental about this. Boring companies are typically great investments. Popular stocks more often than not become over-priced because of dreams of fabulous returns (the Jessica Alba effect we discussed above). It is completely normal for boring companies in boring sectors like utilities, personal products and even healthcare to provide stellar risk-adjusted returns.
Believe it or not, the strange thing here is that Apple has such a high Sharpe Ratio, not Kimberly Clarke. The last decade has been exceptional for Apple due to the smartphone revolution that they brought about.
What happened before the iPhone came along? Lets look at the earlier years of Apple, say 1985-2005:
Apple Inc had higher returns, but it was handily beaten by the S&P 500 on a Sharpe Ratio basis.
What about the whole period : 1985-2015 ; all 30 years of Steve Jobs? A journey through the first Macs, iPods, iMacs, iPads and iPhones? Here you go:
Apple’s sharpe ratio came out bang on target to the long-term market average of 0.4. But it was beaten by a better than expected performance by the S&P 500.
I want you to think about that for a minute. Imagine how smart you would need to have been to have realized back in 1985 that Steve Jobs would create multiple revolutions in the next 30 years and virtually change the electronics industry, human lifestyles across the world etc. And then, everything works just as you thought: Steve Jobs turns out to be an uber-genius, Apple becomes the most valuable company in the world and … still your investment does not beat the market on a risk-adjusted basis. That’s really something! Steve Jobs could not beat the market for you with 30 years of effort. Whoa.
Perhaps you feel that I am too excited about Sharpe Ratios. Apple may have lost out to the S&P in terms of risk but it still delivered an 18% real return vs 8% for the S&P. But that does not matter much because you can leverage up. Lets say you borrowed some extra money and “doubled-up” on the S&P 500. Then you could have made 2 x 8% = 16% return with 2 x 15% = 30% risk. That would have got you almost the same return as Apple Inc, while taking much less risk!
You may be asking how one can double up like that and don’t you have to pay interest etc. Well, all that is needed is a basic brokerage account at Fidelity, E-Trade etc. They have a thing called “margin” which allows investors to do this at very low rates because your loan is secured – they already have your money after all! In fact, even that is no longer necessary – there exist leveraged ETFs on the S&P like SPUU and SPXL which will provide about 2x and 3x returns respectively. But before you start getting any such ideas, please note that nobody in their right mind should “double up” or “triple up” on the S&P 500. Don’t even think it. Please, for God’s sake. Instead, what I want you to appreciate is that when you invest in a few hot stocks like Apple, Facebook, Netflix etc you are effectively leveraged. The high returns you may get are not an accident – you are taking more risk and that is the price of those returns. One day something unexpected will happen and the hot stock will, um “display” its risk. When that happens, it will hurt, and quite possibly you will be left reaching for Kimberly Clarke’s products in the middle of the night.
In that spirit, we should turn our attention to the bond market. In several ways, the story of bonds is older and a lot more interesting than that of stocks. Next time we will talk about it.