The Sharpe Ratio As An Efficiency Metric

Ratios and normalized metrics are used regularly in the hard sciences, particularly when it comes to comparing scenarios and outcomes. The efficiency of a vehicle, for instance, is typically measured in miles per gallon, or the distance traveled per unit of energy. A Toyota Prius at about 50 MPG is without a doubt substantially more efficient compared to say a top fuel dragster.

The financial world has its equivalent of miles per gallon: the Sharpe Ratio, which combines both return and volatility into a single metric

Sharpe Ratio Equation

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Confessions Of An Asset Allocator

Several years ago when I made my first real attempts at managing my own assets the idea of a fixed asset allocation strategy made a lot of sense. Diversify by allocating broadly to a wide range of foreign and domestic securities using fixed income to control volatility. Rebalance regularly, limit transactions as much as possible, and always mind fees. When you run strategies such as these through a back-test the results come out to be fairly decent over many different time periods and market cycles. There is nothing wrong with these strategies, and the vast majority of individual retail investors out there are most likely well served through such investment policies. The difficulty is often finding a strategy that aligns with one’s personal preferences and tolerance for volatility.

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The Five Laws of Gold

The Richest Man In Babylon was originally a collection of parables penned by George Clason in 1926 that focused on the judicious handling of money. Ninety years later these stories are still very applicable to our modern financial lives, with many of the lessons having been repeated numerous times in various forums. For all the time spent analyzing portfolio strategies and understanding asset class behavior there are some foundational concepts that must be in place to ensure personal financial success. Sound advice seldom, if ever, changes.

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Quantitative Value

The idea of buying stocks that are cheap and holding on as they appreciate in value over time is well aligned with the simple heuristic “buy low and sell high.” This central concept has created, for myself, a natural and intuitive pull towards value investing. The problem is that not all “cheap” stocks eventually go on to appreciate in value. Some are cheap for a reason–they have poor prospects and will likely end up in Wall Street’s corporate boneyard.

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Getting Real With Inflation

Inflation is one of the oldest and most well known adversaries faced by investors. Simply put it measures the change in price of goods and services that we purchase or consume including food, fuel, utilities, housing, clothing, entertainment, etc. That being said, investors must achieve a rate of return in excess of the rate of inflation in order to improve their purchasing power.

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Cost of Capital

Good businesses, by definition, earn more than they spend. Those that can’t or don’t simply cease to exist. A quick glance at any corporate balance sheet reveals a wide ranging list of liabilities including: wages and salaries, accounts payable, employee benefits, etc. But there is an additional liability not disclosed on GAAP compliant balance sheets: the cost of capital.

Cost of capital is essentially what a company must pay it’s investors for financing its business activities. It is roughly equivalent to the return an investor should expect to receive for investing in a company.

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Deconstructing Peter Lynch

Actively managed mutual funds have earned their place among the most unloved of paper assets, and rightly so. The high fees combined with persistent under-performance are a serious drag on growing one’s capital. Peter Lynch, famed manager of Fidelity’s Magellan Fund briefly touched on the failure of active managers in his book Beating the Street and even went so far as to suggest allocations to index funds as part of one’s portfolio. This was somewhat prescient as the book was written in the early 1990s, well before the passive investment fad was in high gear. But remember, Lynch himself was an active fund manager. Based on return alone he’s considered among the greatest ever. From May of 1977 through May of 1990 Lynch captained Magellan to an annualized return of 29.06% compared to just 15.52% for the S&P 500.

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