How does Warren Buffett measure risk
Every investor should know these two risk metrics
Volatility and the Sharpe ratio are widely used measures by experts to calculate the risk of an investment. In contrast, two other key figures are more suitable for private investors: the drawdown and the mar ratio.
Many private investors do not know how to assess the risk of individual funds and ETFs or of securities in general. This is not because no tools are available for this - on the contrary, there is a wealth of different key figures that are supposed to depict the risk of a system. But none of them are completely free from drawbacks.
The most important combination of indicators in the financial world are volatility and the Sharpe ratio. Volatility is the real measure of risk. It measures how much the prices of a security fluctuate within a certain period of time.
The Sharpe ratio, for its part, shows how good the risk-adjusted returns on an investment are. To do this, it sets the return adjusted for the risk-free interest rate in relation to the volatility. An example makes things clearer: the volatility of the western stock markets is around 20% on a long-term average. Assuming that the annual return on a stock market is a high 11% and the risk-free interest rate is 1%, the Sharpe ratio is 0.5 ((11% –1%) / 20%). A Sharpe ratio of 0.5 is already above average, whereby the following applies: the higher the value, the better.
Volatility as a measure of risk
There are, however, weighty voices that do not give a damn about volatility as a measure of risk. They complain that volatility has absolutely nothing to do with the risk that is relevant for real investors. Warren Buffett is one of these voices.
In his letter to the shareholders for the 2014 financial year, the star investor explains why he considers volatility to be an unsuitable measure of risk. It does not depict the risk that is actually relevant for long-term investors, namely the risk of permanent capital loss.
The Sharpe ratio is also heavily criticized. One reason is immediately obvious: it treats price gains and price losses equally. But hardly any investor perceives price increases as a risk. In order to remedy this deficiency, the Sharpe ratio was modified to the Sortino ratio. The Sortino ratio works in principle in the same way as the Sharpe ratio, but only takes into account that part of the volatility that is generated by downward movements, i.e. by price losses.
The advantages and disadvantages of the Sharpe ratio
So should investors only use the Sortino ratio because it better reflects investment reality? Or even rely on a different risk indicator, for example the information ratio? The answers to these questions will vary for different investors. But the Sharpe ratio offers private investors two advantages: First, numerous financial websites provide this figure for various investment products. On the website of the Morningstar financial information service, for example, investors can call up the Sharpe ratios of numerous funds and ETFs and compare them with the index and category averages. Other key figures, such as the information ratio, are much less common. Second, the Sharpe ratio enables a quick comparison between different funds and ETFs.
A major disadvantage of the Sharpe ratio as a measure of risk for private investors, however, is that very few investors can calculate this figure themselves. You have to get the key figure from third parties, and it is not always clear which calculation basis they use. And because the calculation bases can differ, the Sharpe ratios of different providers often cannot be compared, even though the key figure is the same. This limits their usefulness.
Two alternative metrics
Because of these disadvantages, a different combination of indicators is recommended for many private investors: the drawdown and the mar ratio. These key figures can also be easily calculated by private investors. This makes it extremely easy to compare different investments. In addition, the drawdown and the mar ratio give a clear idea of the risk with which a return is bought.
The drawdown measures the risk based on the percentage decline from a price high to the subsequent price low. Suppose a share reaches an annual high of CHF 1000, but then drops to CHF 700 before rising again by the end of the year. Then the drawdown for this year is 30% (1000Fr. – 30% = 700).
Of particular interest for this key figure is the highest drawdown that has ever occurred. This measures how high the maximum possible loss an investor could have with a certain investment. In other words, the maximum drawdown measures the percentage of an investor who would have lost if they had bought an investment at the worst possible time and sold it at the worst possible time.
The Mar ratio (the name goes back to a letter on the stock market in the 1970s, the Managed Accounts Reports) is, like the Sharpe ratio, a key figure that shows the risk-adjusted returns. It is calculated by dividing the average annual growth rate of a fund or ETF by the maximum drawdown. The higher this number, the better the risk-adjusted returns. Here, too, an example makes things clearer: Assume that an ETF pays an average of 10% per year. The maximum drawdown that occurs is 20%. Then the Mar ratio is 0.5. As with the Sharpe ratio above, this 0.5 is already an above-average value.
The advantages of the Mar-Ratio for private investors
The Mar ratio has many advantages, including in particular that it is very easy for investors to calculate. However, there is also criticism of this key figure. For example, it is not clear how far back an investor should reasonably go in order to determine the maximum drawdown, for example. For example, the S & P500 has achieved an average real annual return of 7% over the past 100 years. In the financial crisis, the drawdown was around 55%, which leads to a Mar ratio of just under 0.13. In the global economic crisis at the end of the twenties, however, the drawdown was 90%, which means that the Mar ratio is only around 0.08. But should investors really go back to the world economic crisis for the drawdown and the Mar ratio?
There are several possible answers to this question. For most purposes, it seems appropriate and sufficient to go back 30 years if possible. When investors consider this period, their values include both the dot-com crash and the financial crisis. Another variant, which is less recommendable for most private investors, would be that they actually go back 50 or even 100 years, but instead, for example, averages the five largest drawdowns of the period under consideration.
Investors should draw two conclusions from what has been said. First: every key figure has its critics. However, that does not mean that it is not useful. And secondly: Simple key figures that an investor understands and uses are better than those that he does not understand or does not know how to use.
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