Your Portfolio Efficiency Ratio can predict your retirement success and failure. Simply put, this ratio identifies how efficient your portfolio is at earning your returns while keeping your risk to a minimum.
The Sharpe ratio was developed by Nobel laureate William F. Sharpe; this ratio has become the industry standard for calculating the risk-adjusted return. Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return. At OCTO Capital, we find that this ratio is the very best one to use to identify your Portfolio Efficiency.
As a simple example, assume that the portfolio A and the portfolio B both averaged a return of 5% per year over the same time frame. The worst return year was 2008; the portfolio A had a 37% loss and the portfolio B had a 17% loss.
Which portfolio is better? The answer is portfolio B because it achieved the same rate of return with less risk. The portfolio B had a higher Portfolio Efficiency Ratio or Sharpe ratio.
Consider this, from December 31, 1999, to December 13, 2016, Vanguard 500 Index Fund (VFINX) which tracks the performance of the S&P 500 (a common index that reflects the stock market) averaged a return of 4.51% per year. While the average return was 4.51% per year, the fund lost -37.02% in the year 2008.
As an investor, to average 4.51% per year, you had to be willing to lose 37% in a single year.
The Sharpe ratio for the fund over this period was 0.25.
In contrast, over the same time frame, a hypothetical moderate risk portfolio diversified across a few asset classes had a higher average rate of return compared to the S&P 500 index and had the worst return of -17.83% in 2008.**
The Sharpe ratio on this portfolio was 0.71.
In this case, you only had to risk 17.83% of your portfolio to gain even higher average rate of return. It means that a moderate risk diversified portfolio could have outperformed the S&P 500 by 184% on the risk-adjusted return basis. In other words, the diversified portfolio achieved higher returns with less risk.
It matters because the portfolios with lower Sharpe Ratios perform exceptionally poorly when you are taking distributions out of the portfolio. On the other hand, a portfolio with a higher Sharpe Ratio indicates a more stable portfolio.
We at OCTO Capital, focus on building retirement portfolios for our clients that have higher Efficiency Ratio or Sharpe Ratio, portfolios that have a potential to earn a reasonable rate of return while keeping your risk to a minimum.
Do you know what your Portfolio Efficiency Ratio is?