"...when it seems to good to be true... it probably is..."
What is
the Sortino Ratio?
It turns out we can. In finance there’s a metric called the Sortino Ratio. It
measures return relative to downside volatility (a variation of standard
deviation). A higher number is better than a lower number, but
the number can get higher in a few different ways –
returns can go up, downside volatility can go down, or both returns can go up
and volatility can go down simultaneously. Higher returns by themselves
are not enough to make the metric move, if they come with more downside
volatility.
Sortino
Ratio = Return / Downside Volatility
Over the 10- and 15-year periods ending January 31, 2018, the Sortino Ratio for the S&P 500 Index was 0.99%
and 1.08%, respectively, according
to Morningstar. But over the past 3- and 5-year periods, the Sortino Ratio for the index has been 2.67% and 3.10%,
respectively. Clearly we’ve been spoiled with 3-
and 5-year periods of high returns with little downside volatility –
around triple the ratio of the longer term periods. Over long periods of time,
the market doesn’t deliver such robust high volatility-adjusted returns.
See chart
Source:
Morningstar
Ironically, the fraudulent Sortino Ratio of Bernie Madoff’s
hedge fund was 2.95%.
Madoff didn’t advertise market-beating returns, but returns that were close
enough to the market’s with hardly any volatility. Somehow
– probably with the help of very low interest rates and investor psychology – we’ve gotten a Sortino Ratio over the last 3 and 5 years that
roughly matches that of the Madoff fraud
Lessons
for Investors
The first obvious lesson for
investors during this bout of volatility is that
periods of uninterrupted returns don’t last. A
correction is a normal part of investing. It’s not that investors get paid for enduring
volatility, as some theories suggest; it’s that volatility is simply the price
of admission into the stock market. Returns or getting paid comes
from being careful about how much you pay for stocks.
2nd. Another lesson is that investors should have an
appetite to start buying when prices drop. If you don’t feel like buying, but,
instead, want to sell, it’s very likely your allocation wasn’t correct to begin
with. Nobody likes to see any part of their portfolio decline, but if the decline has hit a piece of your assets that
doesn’t make you want to throw in the towel, that’s a good sign. Stocks
may still be to expensive, but a good investor should at least be thinking
about buying during and after big declines. In fact, if you’re still employed
and making automatic contributions to 401(k)s and other accounts, take some satisfaction
in knowing that you’re contributing new money to your retirement accounts, and
buying stocks at lower prices.
Third,
take this bout of volatility as an invitation to rebalance your portfolio and
reassess how much stock exposure is really appropriate for you. Many people fill
out asset allocation questionnaires when they set up financial plan, and those
are generally good things to do.
Last, get updates from your
advisor about the market’s Sortino Ratio. It’s been around 1 for a long time. If it starts flashing anything over 2, and gets near 3, you
know things have been too calm and returns have come too easily.
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