I’ve read plenty of vitrol about the Sharpe Ratio (return divided by volatility) and how dangerous is can be and how insufficient it is as a measure of risk, but I’ve never been one to go all black & white about any piece of information. I find it hard to believe that something valuable can’t be gleaned from what it is saying to an investor, at least on a relative scale. My current experience with UP (Uberman’s Portfolio)?has brought it to my attention just how much of an uphill battle we often create for ourselves when we invest. Part of why UP has done well in recent times is that it’s a rare blend of high yields on reasonable volatility with very dynamic risk control capabilities such as low costs and small incremental lot size. In other words, the Sharpe Ratios in the forex world are historically high. The volatility of the markets, especially when diversified, is not a large multiple of the yields.

Now take a look at the US stock markets. The S&P 500 has a long-term Sharpe Ratio of less that 0.5. To put this in perspective, it’s generally considered “good”?if an investment strategy has a Sharpe Ratio near 1 and hopefully greater. What this means is that relative the return one can expect from stocks, the volatility is way to high. Now this sounded like an oversimplification to me so I decided to perform a little test. I took the full set of SPDR ETFs, representing various sectors and build a sort of UP-like portfolio out of them. It was nearly impossible to create a portfolio that could manage a decent Sharpe Ratio and consequenly a resonable yield/drawdown ratio. This was based purely on dividend yields mind you and so doesn’t factor in market timing. But I think the point remains valid because any investment can be made good with brilliant timing. I wanted to compare market-neutral strategies so that I was truly taking what the market is willing to give me no questions asked: yield and volatility. Yield in currencies are interest rates and yield in stocks are dividends. So the conclusion seems to be that unless you are a good timer, stocks are an uphill battle with risk. Certain investments have volatilities closure to their yield than others. I just think it’s amazing that something as popular as stocks have so steep a profile. Stock volatilities are almost always double digits and often over 20% long-term. Most currencies top out at 10-12% historically. Yet yields are similar. All else being equal, the choice seems obvious…for now. Things can change tomorrow and I’m not trying to tout currencies above all else. I’m just trying to point how what’s important when thinking about your portfolio of whatever.

Of course, one might feel they have a better sense of timing in one versus the other and that shouldn’t be discounted. But if anything, stocks are far from being the more “conservative” everyman investment they are made out to be, while more exotic things like forex seem to be much more suited to the risk-averse if handled with some basic care. It’s the overuse of leverage (see Jason’s posts on hedge funds), which you don’t have to use, that deserves the blame for this rep. This is just one facet of any investment decision so I don’t mean to overgeneralize. In fact, I’m reminded of the old adage that the greater the risk the greater the reward. I’m just going out on a limb to see what fruit I might find.