Quantitative Methods #4: Volatility Against Returns

Yesterday we discussed risk measures such as variance and standard deviation. However, looking at a risk without an expected return is like bread with no butter… Something is missing. CFA material puts a lot of importance on different ways to look at risk tied with the expected return. These would basically try to capture the “excess return” per unit of risk. There is not one superior way to do this. You do have to know each of these by name.

Sharpe ratio (the most known one):

This one will capture the risk of the portfolio/asset that is in excess over risk free and divide it by the standard deviation. The higher, the better, obviously.

Roy’s safety-first ratio:

In this case, the RL would be the lowest amount of risk that can be tolerated by the investor.

Finally, another measure that could be used when you have different probabilities is the:

Expected return and Expected Standard deviation

Such measures are obviously superior to a return measure that you mustk now but that doesn’t account for risk, the Holding Period Return:

Return = ( (Price end + Dividend) / Price start ) – 1

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