Standard Deviation -Standard deviation is a measure of how spread out values are in a series of returns. In calculating the standard deviation, it gives investors a “standard” way of knowing what is normal, and what is outside the range of normality. A lower standard deviation is better, and it means returns are more likely to be in a narrower range, whereas a larger standard deviation means returns are more likely to be scattered and less consistent. Standard deviation can be calculated based on multiple time horizons, most commonly monthly and yearly. Standard deviation should be assessed in conjunction with the monthly and/or yearly returns to grasp whether the investment is worth considering. Again, the main thing to remember is that the smaller the number the better. For a more detailed discussion please read, A Better Measure of Risk: Standard Deviation or Downside Deviation?
Downside Deviation – Similar to standard deviation, downside deviation measures how spread out values are in a series of returns, giving investors a range of returns to expect in the future. The difference between the two, however, is that standard deviation takes into account both positive and negative returns, whereas downside deviation only takes into account the negative returns. Downside deviation throws out the positive values in a return stream, eliminating positive volatility from its calculation. Many advisors put a heavier emphasis on downside deviation versus standard deviation, because it gives us a better understanding of what to expect in terms of risk. Similar to standard deviation, the lower the number the better, as we want downside deviation to be as close to 0 as possible. For a more detailed discussion please read, A Better Measure of Risk: Standard Deviation or Downside Deviation?
Maximum Drawdown – The maximum drawdown in an investment references the largest peak to valley loss during the course of any investment. Maximum drawdown is usually calculated based on monthly returns, however it is most effective looked at based on daily figures. In terms of a figure, maximum drawdown is relative to the overall investment and should be assessed based the investments average annual rate of return (ROR). The lower or smaller the maximum drawdown the better. A maximum drawdown nearly half of the average annual ROR is considered to be really good. For example, if an investment has an average annual ROR of 20%, a maximum drawdown of -10% is considered to be good. For a more detailed analysis of drawdown’s, please consider reading one of our earlier posts, The Drawdown Report.
Risk Adjusted Statistics
Sharpe Ratio – Sharpe ratio is probably the most commonly used risk adjusted ratio throughout the investment universe. Sharpe ratio is a measure of risk–adjusted performance that indicates the level of excess return per unit of risk. In summary, the Sharpe Ratio is equal to compound annual rate of return minus rate of return on a risk–free investment divided by the annualized monthly standard deviation. The greater the Sharpe ratio the greater the risk–adjusted return and we would like to see this number as high as possible. Usually speaking a Sharpe ratio of 1.0 or greater is considered to be good and essentially implies that for every unit of risk you are assuming you are achieving an equal amount of return. In short, the larger the Sharpe ratio the better. One thing to closely consider, is the risk free rate used in the calculation which can greatly affect the final number. For a more detailed analysis, please read, What is the Sortino Ratio?
Sortino Ratio – Sortino Ratio is another risk adjusted statistic used to quantify risk to reward. Very similar to how the Sharpe ratio measures an investment based on its risk, the Sortino ratio also does the same except it takes into consideration only downside deviations (volatility of only negative returns) within the investment as opposed to the standard deviations (volatility of both positive and negative returns) that the Sharpe ratio uses. Many investment advisors and/or professionals argue that the Sortino ratio is a better measure of risk. Similar to the Sharpe ratio, the larger the Sortino ratio, the better. A Sortino ratio greater than 2 is consider to be good. For a more detailed analysis, please read, What is the Sortino Ratio?
Sterling Ratio – Sterling ratio is another helpful risk adjusted statistic, however it is less widely used within the investment universe. Like the Sharpe and Sortino ratio’s, the Sterling ratio looks to quantify risk to reward. The Sterling ratio, however, takes a slightly different approach then the Sharpe and Sortino. The Sterling ratio is calculated by taking the compound annualized return over the last 3 years, and dividing it by the average yearly maximum drawdown over the last 3 years, less an arbitrary 10%. To calculate the average yearly drawdown, the latest 3-year returns (36 months) are divided into 3 separate 12-month periods, and the maximum drawdown is calculated for each. These 3 drawdowns are then averaged to produce the average yearly maximum drawdown for the 3-year period. (If there are not 3 years of data, the available data is used). Like many other risk adjusted statistics, the higher the Sterling ratio the better, showing that the investor is earning a higher return relative to the risk.
Calmar Ratio – The Calmar ratio is most similar to the Sterling ratio in its calculation, it takes the average annual compounded rate of return and divides it by the maximum drawdown for that same time period, usually over a period of 3 years (however when 3 years worth of data is not accessible, then the available data is used). Like many of the other risk statistics, the higher the Calmar ratio the better with anything over 0.50 is considered to be good. A Calmar ratio of 3.0 to 5.0 is really good.
Skewness – Skewness is measured as a coefficient, with the ability for the coefficient to be a positive, negative or zero. The coefficient of skewness is a measure for the degree of symmetry in the monthly return distribution. It allows investors the ability to determine where the majority of monthly returns are going to fall and also point out any outlier events. It’s difficult to assess an investment based on the skewness coefficient alone and other risk statistics must be taken into consideration along with the skewness to make the best investment decision. We would recommend reading a more detailed article we wrote on skewness, What is Skewness?