Part 3 of Our Ongoing Saga About Risk, Which Is Fortunately A Trilogy

Here’s Part II. No, wait: Here’s Part I. Read those first, there’ll be an open-book quiz.

We’re explaining what all these mutual fund risk measurements mean. Yes, you want to know how much your mutual fund has gained and might likely gain, but the professionals have collectively decided that you need to know not only your fund’s propensity for gain, but how risky said fund is. Thus they applied some formulae to price swings, creating α, β, R², σ (that’s a lowercase sigma, the equivalent of the Roman letter S, the first letter in “standard deviation”), and two other quantities that are named after people with Anglo-Saxon names and thus aren’t symbolized with a Greek letter:

One more DODGX screenshot

Sharpe and Treynor ratios. What are they and do we care? Let’s answer the 1st question 1st.

William Sharpe is a 79-year-old Stanford professor and Nobel laureate. Decades ago, he tried to determine how much of a given investment’s returns are due to sagacity on the part of the investor, and how much are due to risk. If black 17 comes up and pays you 36-to-1, that means you’re 0% a shrewd roulette player, and 100% someone who benefitted from the inherent risk. The formula for the Sharpe ratio is relatively simple, so much so that it’s kind of amazing no one thought of it before the 1960s.

Start with the investment’s average rate of return, in this case over a 3-year period as indicated in the chart. Subtract the best available risk-free rate of return, like what you’d get from short-term government bonds – 10-year T-bonds, to be specific. Which, over the last few years, has been effectively zero. Then divide the difference by the standard deviation, which we explained Wednesday and which is a measure of how much monthly returns fluctuate with regard to the average. The theory goes that if you measure an investment by its excess return per unit of standard deviation, you’re focusing on how well the investment does on its own merits rather than how well it’s doing given its inherent risky nature.

The advantage of Sharpe ratio over α and β is that Sharpe ratio rates an investment on its own merits, rather than against a benchmark. The downside is that our denominator, standard deviation, can fluctuate for a host of reasons.

So what does a Sharpe ratio of 1.19 mean? Is it high, low? As always, it depends on the asset class. As you can read, Sharpe ratios in the Dodge & Cox Stock Fund’s asset class run around 1.12. DODGX beats the average by a few points, meaning that the data could be interpreted as evidence that DODGX’s managers are operating more on skill and less on luck than are their counterparts and competitors. T-bills have a Sharpe ratio of 0, and of course return less than T-bills’ means a negative Sharpe ratio. With time, as returns normalize, Sharpe ratios reduce. DODGX’s Sharpe ratio over the last 5 years is .59, and over the past decade .45.

Jack Treynor is a financial analyst with fewer academic credentials but almost certainly more money than William Sharpe. He developed his competing ratio a few years before Sharpe. Treynor ratio is identical to Sharpe ratio, except the former divides excess return (over T-bills) by β instead of by standard deviation. In other words, Treynor ratio measures returns with regard to market risk, instead of total risk. DODGX’s Treynor ratio is greater than the category’s Treynor ratio over the past 3 years. And the past 5 years, but not the past decade. Again, Treynor ratio compares returns with regard to volatility with respect to a benchmark. Neither Sharpe nor Treynor ratio has anything to say about how actively a fund or a portfolio is managed.

None of this is anything but mathematical masturbation. It’s dividing quantities by other quantities purely for the fun of it. As an investor, your objective is to make money. Not to beat benchmarks, nor to gauge your investments with regard to inherent and/or systemic risks. Most of the wealthiest people we know have no familiarity with any of these measurements, and wouldn’t see any reason for knowing how to calculate them.

You can choke on theory, or you can buy assets and sell liabilities. It really isn’t more complicated than that. The various risk measurements are nothing more than intellectual curiosities, the kind of stuff that the Nobel committee loves and that university business schools love even more. After all, it’s more material to add to the curriculum.

Furthermore, there’s a reason why every last piece of financial advice is punctuated with the following phrase: Past performance is not necessarily indicative of future results. α, β, R² etc. are incredibly helpful if you plan on traveling back in time and making investment decisions in the fall of 2010. In the market, there’s no better investment than a temporarily wounded stock. Until the academics learn how to quantify the implications of a Carnival Corporation ship capsizing or an iteration of Microsoft’s Windows 8 software being released with bugs, you’re better off looking for something undervalued and exercising patience.

 

 

A Rebuttal

(To this, specifically.)

 

This man once wrote a blog post entitled “The Value of Personal Appearance.” No joke. 11/16/06.

 

Dear CYC,

I just read your “article” and boy I am steamed.
I am more steamed than the steam that powers my at-home micro-generator (Hey, thanks for asking! Did you know that a tea kettle, a steel hamster wheel and a small magnet can generate enough power to recharge a AA battery in only 7 days? So long, Big Electric!)

Back to the topic – I cannot believe what a waste that article was. I don’t mind the hour that I spent disecting it – as we know, time has no value – but after a few more hours crunching the numbers, I realized that you cost me $0.0012 of electricity for my computer monitor. Thankfully that is much less than most people would pay (Hey, thanks for asking! Did you know that if you set your monitor’s brightness to its lowest level, then light a few homemade candles, you can nearly make out the words – while saving almost $0.00001 per hour? So long, Big Computer!)

Even so, $0.0012 is no trifling matter and I demand reimbursement. I’m sending you a self-addressed stamped envelope and I expect a speedy response. Or less than speedy. Either way, really – after all, you can’t put a time value on money.

I know you may be tempted to ignore this message, but that would be unwise. Unfortunately this isn’t the first time someone of lesser status (and by that, I mean someone with fewer page hits) decided to attack me. So, I have my own lawyer, who I got for the low cost of $9/hour (Hey, thanks for asking! It turns out that if anyone knows how to negotiate for small change, it is that guy who lives between the 1-train grate and the 9th street dumpster. Even better – like most of the homeless folks in this city, he has a law degree from a “boutique” law school! So long, Big Law!). He’s already spent 28 hours on this case, so he is more than ready to take you to court unless I see that $0.0012 pronto!

OK, with that ranty-rant of my chest, I’m a bit more calm. But, I still think you need to learn a lesson. So, let’s turn the tables and see how you like a little razor-sharp satire:

Hi! I’m Control Your Cash. I talk about my fancy dinners paid for by the poor renters of my many properties. And I waste money on things like driving and showers that last more than 90 seconds. Plus I just buy gas wherever I feel like it, even if the station across town is .099¢ cheaper. I think people should buy things like rental properties and stocks and “assets” – which are really expensive, by the way – instead of safely stashing money in their hand-carved piggy banks. I wouldn’t know how to make my own toothpaste if my life depended on it, and I’ve never even HEARD of fecal reclamation. Yet I try to tell people how to handle their money. Funny, huh?

Worst of all, I am mean. Just plain mean. For example, I never, ever encourage people’s dreams of being the first in their family to obtain 7 degrees, or of completing the liberal art trifecta (English major, master of art history, and an unplanned pregnancy). And I make fun of those who pay down their smallest, lowest-interest loan first even though SCIENCE has proven that a debt snowball is the best way to make someone feel better about themselves.

And I just wrote an entire article mocking plus-sized people just because they like a little candy and pizza with their workout. And I wasn’t mocking them for buying corporate candy instead of making their own from tree sap and orange juice – that would actually make sense. No, I was mocking them for trying to get into shape while having a little fun and a lot of burritos. That is a judgment. And people don’t want to hear judgments or opinions on blogs – they want recipes for homemade bubble gum (Hey, thanks for asking! Did you know that the easiest way to make your own bubble gum is to boil 15 pieces of used bubble gum along with a dash of glue for 10 minutes? I didn’t know that because I’m not Trent, so can’t say So Long, Big Bubble!). Telling plus-sized people that they won’t get in shape by drinking a Frappuccino while watching other people exercise hurts their feelings.

But I don’t care about that, because I have no feelings. Which is a shame, because that is what money is all about – feelings. But I wouldn’t know that, because I’m not Trent. I am CYC.

See, it doesn’t feel so good, does it?

Unless you want more of that, perhaps you should go pick on someone in your own league, like that uppity lady at AffordAnything.com. I have better things to do than keep talking to you.

Now, if you’ll excuse me, I’m going to go hand pick the grass on my front lawn (Hey, glad you asked! Did you know that a gas-powered motor costs almost $0.30 per mowing? Even a goat costs almost $0.15, and the composting benefit they provide is worth at most $0.05. Meanwhile, I can do the job for free while getting the same $0.05 composting benefit. So long, Big John Deere!)

Toodles,

Trent

(Note: Guest contributor Pseudo-Trent is an international vice president with a famous multinational firm who has way too much time on his hands. Follow him on Twitter @DubaiAtNight.)

Consider Growing A Pair

Stop pondering. Stop considering. And while you're at it, get rid of that ridiculous facial hair.

 

WARNING: Self-reference coming hard in today’s post.

It’s the weakest, foulest word in the English language. It’s the first line of defense for the timid and the recreant. Most of the time, when someone uses it he’s saying, “I don’t have the strength of my convictions. In fact, I might not even have convictions. Essentially, I’m saying nothing.”

The word? “Consider”. As in, “Consider raising your real savings percent after 401K contribution to 50% as soon as comfortably possible” (sic). Or “consider buying last year’s (consumer electronics) models” to save money.

The author wants us to consider saving half our income, in the roundabout way he phrased it? Okay.

(pause)

Done!

Let’s consider some other things. We’ll start by considering moving to Wyoming with its business-friendly tax climate. Then, let’s consider buying a fuel-efficient and relentlessly douchey Nissan Leaf, so we can simultaneously save the planet and look down our noses at the Prius owners.

(pause)

Done! Again! This considering business is easy.

Let’s see if “consider” becomes any more robust when used in a non-personal finance scenario:

Your friend: My boyfriend gave me a black eye last night. He said he’d give me another one if I didn’t have dinner on the table by 6:00 sharp.

You: Consider ending the relationship.

Any site that – or for that matter, any person who – tells you to “consider” doing something might as well sit there silent. It’s an effete way of attempting to make a point, which doesn’t stop countless other personal finance bloggers from doing so. Largely because they have nothing important nor interesting to say. We promise never to use the word on this site, at least not in that particular context.

That being said, here are a couple of financial steps you should take. Don’t “consider” taking them, just freaking take them. Or not, and be poorer:

1. Get a credit card with, in ascending order of importance: no annual fee, either cash back or rewards for something you use anyway, and a big limit.

Practically speaking, you can’t rely on cash for everything. (For instance, buying event tickets, renting a car, or buying expensive items that it’s impractical to carry cash for.) And you need to build credit, which you can’t do if you conduct business solely in cash. The bigger the limit, the less you have to rely on cash (and the more the issuer will entice you with offers unavailable to its customers with smaller limits.)

Convenience, discretion, and disclosure are major reasons for using a credit card. “Disclosure” just means that you have a paper trail in case you have any discrepancies. It’s hard to dispute a $3000 transmission replacement done by an incompetent auto technician if you paid cash.

Oh yeah, we neglected to mention interest rate. Who cares? Interest rate is meaningless. You know how much every credit card issuer charges on balances paid by the due date? 0%, without exception. We’re assuming you’re paying your bill in full every month, thus letting the credit card issuer profit off its hundreds of thousands of other cardholders. If you aren’t doing this, you shouldn’t be buying things with a credit card. In fact, you shouldn’t be buying things, period.

2. FORGET about “building an emergency fund”, the go-to financial advice from people who either don’t know what they’re talking about or are too lazy to think about the issue critically.

It sounds great in theory. The very name “emergency fund” implies that you’re avoiding the possibility of spending your retirement years holding a sign on a street corner because you sat there unmotivated while misfortune struck.

What are true emergencies?

-House burns down
-Contract lethal case of malaria or some other fatal disease.
-Get fired.

There are probably others, but these and variations were the most common ones cited in our informal poll. And every last one of them, you can insure against.

Having an insurance policy in effect on your residence is pretty much a law. Even if it wasn’t, the chance of your home burning to the ground is almost negligible. Control Your Cash world headquarters is located in a city with 240,710 “housing units”. Last year there were 396 residential fires in the city, and of those, only 20 resulted in the house becoming uninhabitable. Assuming that people are as likely to smoke in bed in any other part of the country as they are here, that means you have about a 12,000-to-1 shot of losing your house. And again, even if that happened, you’d almost certainly be covered.

What about health?

Well, what about it? Again, there’s this thing called insurance. You buy it, it covers you. If you think a sufficiently comprehensive policy is too expensive, then a) how much were you planning on committing to your emergency fund and b) what did you think such an emergency fund was going to pay for if you had to tap it?

And if you lose your job, again, unemployment insurance. You’ve been paying into it for years. Never mind that losing a job is the best thing that could possibly happen to many people, exactly how far is an emergency fund supposed to take you after you lose a job?

If you’ve got excess cash that you’re antsy to save somewhere, put it in your 401(k). Invest in an undervalued stock. Whatever you do, don’t be like this idiot and put an extra $1000 a year in a savings account where it’ll stagnate and won’t gain a penny of interest. Plus you’ll forgo the opportunity to have put your money in a place where it could have actually built wealth.

There. Now instead of considering subscribing to our RSS feed, do it. Click this link. You’re welcome.