Portfolio Efficiency

If you were to design a system to pump water up a hill, would you account for the efficiency of the pump in your design?

Of course you would!

You want to know that you are producing the flow you need while using the least amount of power.

The design of your investment portfolio should not be any different. You should want to get the most output per unit of input.

In the case of investing, the input is volatility risk and the output is the risk premium you expect to earn by taking on risk.

If you aren’t willing to take any risk, you could just own cash. If you want to attempt to earn a risk premium or “excess return” above the rate of cash, you need to be willing to take “excess risk” above the rate of cash.

The amount of excess return you achieve per excess risk taken is called the Sharpe ratio.

Sharpe Ratio = Excess Return / Excess Risk

The Sharpe ratio is one of the primary metrics used to measure efficiency of investment return. In the same way that you want to choose an efficient pump, you should want to build a portfolio that has a high Sharpe ratio.

If you look at the title image (also below), you will notice a solid line drawn between the “cash” and “portfolio” dots. The slope of this line is the Sharpe ratio of the portfolio.

To take this a step further, consider your favorite formula from algebra:

y = m*x + b

If we convert this formula for our purposes, we get:

Portfolio Return = Sharpe Ratio * Excess Risk + Return of Cash

Think of this as the equation that represents the performance of your financial pump.

The portfolio return is like your desired output or flow rate.

The Sharpe ratio is like your pump efficiency.

The excess risk is like your energy input.

Here are a few takeaways about the equation:

1. We can't control the rate of cash. It's effectively just a constant in this equation.
2. We have some control over the Sharpe ratio. The best we can do is diversify our assets as much as possible and hope for the best. Just keep in mind that there is no guarantee that diversification will lead to a more efficient portfolio.
3. The main variable that is within our control is the amount of risk we take. If we have a longer time horizon, we can afford to take more risk in hopes of harvesting more risk premium.

I'll leave it there for now. Short and sweet. In the next edition, we will break down the Sharpe ratio equation a bit further to see how diversification can potentially have a positive effect on efficiency.