The Best Way To Measure Your Risk Vs. Return

What the hell is going on with GameStop?

GameStop saw yet another rally this past week partially fuelled by a man named Keith Gill, the owner of an X account called “Roaring Kitty”, one of the key figures who helped propel the stock to new heights back in 2021.

Less than a week ago, the stock hit a high of $64.83, up more than 200% from its close on May 10th.

However the hype failed to last very long, with shares tumbling almost 20% on Friday after the retailer said it plans to sell 45 million class A common shares and reported preliminary results that were, well… disappointing.

A Wedbush analyst, Michael Pachter, who covers the stock said that the company is “not in a position to be profitable”.

As per Michael, they made $6 million last year and burned all kinds of cash. The consensus is that they lose $100 million a year going forward and that they have “no plan that would suggest they can grow revenues or profits”.

DD’s Take:

I like to watch these meme stocks from the sidelines. I have zero FOMO but find it interesting how one single person can have such an impact on the stock market, causing dying businesses to skyrocket with no real substance for growth.

I’ll be keeping tabs on how this story unfolds once again, but to enter into a position in this stock would be gambling, and that goes against my investing principals.

A Ratio You Didn’t Know You Needed

The Sharpe Ratio

The Sharpe ratio is a financial metric that tells investors how an investment is performing relative to its total risk.

The higher a stocks investment risk ratio is, the more of a return it will offer relative to its risk. The reverse is also true.

This ratio is used in long term investing, so if you’re a day trader you can stop reading now.

Let’s dive in.

Every investment you make is going to come with some sort of risk. Understanding these risks puts you at an advantage over the average investor.

Why?

Because people will blindly buy a stock based on the “promise” of 100x gains without ever knowing the risk associated with it. Then whine when the stock price falls 40% and call the stock market a scam.

How can this be avoided?

By understanding the risks of what you’re buying.

Before you dive into a new investment, it’s vital that you understand whether the time and money you put in will be worthwhile.

This is where the Sharpe ratio comes into play.

So what is this magical ratio?

It’s a financial metric that will allow you to determine whether the risk you’re taking on has generated high enough returns compared to the returns you might have seen without taking on risk.

You can evaluate it on individual stocks or even your entire portfolio.

Here’s how you calculate it yourself.

But don’t worry, you can google the ratio and save time instead of doing math.

To calculate the Sharpe Ratio on your portfolio you need:

• Your portfolio’s rate of return or expected rate of return

• The risk free rate (Treasury Bills for example)

• The standard deviation of your portfolio’s excess return

Let’s look at an example:

Say you own one single asset called Stock ABC.

Stock ABC has a 5-year return of 50%.

The 5-year treasury bill has a risk free rate of 4.5%.

Let’s assume the standard deviation is 15%.

Sharpe Ratio = (50 - 4.5) / 15
Sharpe Ratio = 45.5 / 15
Share Ratio = 3.03

What does this mean?

Less than 1 = bad

1+ = good

2+ = great

3+ = excellent

A higher ratio means that the risk you’re taking on is paying off in the form of returns that are considered “above average”.

If you find yourself with a Sharpe Ratio of 0, that’s a bad sign.

It means you’re taking on risk to generate a return that is matching the “risk-free” treasury bill rate.

Let’s look at some common companies and their respective Sharpe Ratio’s:

• Apple = 0.52

• Nvidia = 4.17

• Amazon = 2.35

• Costco = 3.58

• Walmart = 1.77

• Tesla = 0.88

• AliBaba = -0.26

From this list, you can see that Nvidia’s and Costco’s returns relative to their risk are the greatest. This doesn't mean they’re necessarily good long term investments, however over the past 12 months, investors have been rewarded greatly for the risk they took on.

See you in the next one!

Alex (The Dividend Dominator)
Founder and CEO of Dividend Domination Inc.
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