Where Has The Protection Gone?

"The Sharpe ratio measures the excess return (or risk premium) per unit of deviation in an investment asset or a trading strategy, typically referred to as risk, named after William Forsyth Sharpe." - Wikipedia

"If you are not willing to risk the unusual, you will have to settle for the ordinary." - Jim Rohn

"This report, by its very length, defends itself against the risk of being read." - Winston Churchill

In the world of finance the Sharpe ratio is a key aspect of investment.  What you want is a high Sharpe ratio meaning for every unit of risk that you are taking you are receiving more than a fair share of reward in the form of return.  For example, if you invest in a highly speculative stock that has a good chance of providing you with returns of 50% a year for the next five years and only a small chance of a loss, this position would provide you a high Sharpe ratio.  Taking this one step further, funds are measured against an index and those that beat the index with a low level of volatility (risk) provide the investor with a high Sharpe ratio.  They provide the investor with a higher return for the same or lower amount of risk.  As an investor this is what you want!

So how is a high Sharpe ratio achieved?  The easiest way is to find a basket of diverse investments that produce a high rate of return.  This sounds easy and in many instances it is sold as being easy to do, but a recent study showed that not only do most investments have poor Sharpe ratios but that these numbers are dropping.

The first problem is that in the modern world of finance finding or creating a diverse portfolio of investments is almost impossible.  Most people are ignorant to the fact that buying an array of mutual funds does not achieve the diversity that they need.  This is due to the fact that many of the mutual funds hold the same investments even if they call themselves different things.  For example a growth large cap fund and a value large cap fund more than likely have as their largest holding Apple.  Buying both of these means that you are now doubly exposed to a movement in the price of Apple.  This is great while it goes up but it is not a diverse portfolio.

A greater problem for the prudent investor is that the value of diversifying is losing its merit at precisely the time that it is needed most.  The way that a portfolio is created is by finding investments that are not correlated to one another.  As an example if you know that Apple will go up in price if the price of the raw materials of copper and nickel go down because Apple's profits will rise, then it would be said that copper and nickel have a negative correlation to Apple stock.  So by buying all of these you would be protected as if Apple goes up copper and nickel go down.  The one offsets the other.  This reduces the risk of the portfolio but in this example would not provide you any capital gain.

In the real world it is impossible to find a correlation as perfect as this so money managers and investors look for investments that will not move in exactly the same direction or at the same speed at the same time.  The idea is to weight the portfolio to capture some upside while limiting the downside which results in a properly diverse portfolio.  Now if this portfolio beats the index tracked then it would have a high Sharpe ratio as the risk of the overall portfolio is reduced and it is still producing gains in excess of the market.  This is the holy grail of investing but it is seldom if ever achieved.

The reason for this is many fold and I will delve into a few reasons here.  The first reason is that correlation between asset classes are constantly changing.  The trader knows that correlation trades last until they don't, meaning that you should trade the relationship until it breaks.  A classic example of this was that up until recently if the dollar strengthened the market went down and vice versa.  A great trade would therefore be to be long the market and the dollar and pocket the spread, however that correlation has weakened recently breaking the trade.  In a portfolio to properly handle this constant change in correlations you need to constantly change your portfolio allocations.  This comes with the added risk of the cost of moving the investment and the fact that once you have moved you may miss a good run in the position that you just sold.

The second reason is that correlations between all assets are becoming more closely linked.  International stocks used to be a good hedge against movements in the United States back when I got into this game in 1985, but now they all move together.  I also remember a time when commodities were a great hedge but nowadays that is also gone.  Think about copper, it seems to lead the market lower or higher as people use it as a leading indicator rather than as a hedge.

Finally, as we have seen during the recent market melt down, at the exact time that the diversification is needed to protect your portfolio (when the market explodes) is the exact time when correlations move together and everything gets killed at once.  So while countless hours are spent trying to build a perfect portfolio to protect against Armageddon, when that day shows up everything is pounded at once eliminating the desired protection.

So what is one to do?  As with all studies it is far easier to link the main investment opportunities together than to dig for things that lie outside the box.  For one, most people and most studies exclude private equity investments.  This is why these are not typically linked to other investments.  Just because the market is tanking does not mean that your investment in privately held regional Internet or biotech company has been impacted.  Looking further, while local real estate markets are being pounded does not impact the short sellers or the buyers of foreclosures, in fact it benefits their business tremendously.

I remember being an analyst in the early 1990's during that recession and while many of my friends were struggling our business was flourishing.  The reason was we specialized in bankruptcy and commercial litigation, both of which are busiest during recessions.  The key to the story is to look at your portfolio and see what your true weighting is in each asset class and then try to find something that will provide a level of protection if and when the market collapses.

As with everything there are no guarantees but hiding the money under a mattress comes with its own set of risks such as loss to inflation, risk of theft or being lost in a fire.  Look at alternatives to the standard investment portfolio and it should stand you in good stead during these tough times.