The Return-to-Risk Ratio
A combined metric
It turns out, there is a very simple way to combine the return and risk metrics discussed in the last post into one simple metric. Just divide the two numbers!
By taking the average return over a period of time and dividing it by the risk as measured by standard deviation, you get a metric for the return per unit of risk offered by a given investment. Here is what that looks like for our ongoing example:
Over this short time period, stocks presented a better risk-to-return ratio than bitcoin. This is kind of surprising since bitcoin provided a better return than stocks on average during this time. But, that’s the power of analyzing both offense and defense.
In an extreme example, if someone made a 5% return in one day, you might be impressed until they told you it came from the bet of a coin flip where one side was win 5% and one side was lose 50%. That’s a super risky investment and ill-advised bet, even if it happened to turn out positively.
Remember though that risk is about uncertainty of outcomes, which can include both positive and negative events. For some people, they like risk. Even if the return-to-risk ratio for a certain investment is lower, someone may still want to invest because they are seeking a higher return. There are always going to be counter examples out there.
Return-to-risk analysis is meant to address generalized investor behavior and is a starting point. Any sort of customized analysis for a specific person can be a next step.
This framework has also been around for a long time. If you want to learn more about it or dig deeper into the extensive research, check out the Sharpe ratio. It’s pretty much this ratio but with an extra variable added.
The bottom line is, an investment’s potential return should never be analyzed without considering the potential risk. It’s easy to get caught up in the allure of chasing big returns but that may not be a wise strategy when the risks are considered.
Return and risk are inseparable. Don’t ignore one side. Even the flashiest offense can lose if there isn’t a good defense.