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Dear Investment U Reader,
 There's a nasty four-letter word that many investors dare not say. It's a word that has them so full of fear that they'd rather do nothing than take a chance to grow their money.
"Risk" is always a factor in investing. In fact, the way we manage risk is what most ultra-wealthy investors would say is the key to their success.
In this week's episode of Steve McDonald's popular Slap in the Face Award, he asks an eye-opening question. It should make you think twice the next time you think the stock market is filled with too much risk.
And, most important, it should have you asking a simple question. "Is there an easy way to measure risk?"
Click here to watch the video
The answer is yes...
Risk should be avoided when the danger outweighs the potential return. We can all think of real-life examples.
Many times it's hard to quantify the "value" of a risky move. But in the investing world, nearly everything is measurable.
When it comes to measuring the value of risk, we turn to the Sharpe ratio - a Nobel Prize-winning formula devised by William Sharpe. It's incredibly simple.
The Sharpe ratio tells us how much additional return we should expect for each additional unit of risk. After all, if we're taking risk... we want to get paid for it.
This sort of ratio sounds complicated, I know. But there are only three parts to this equation. All we need is an asset's historical return, the standard deviation of its share price and the return for a typical "risk free" asset.
That last variable is an odd one. It depends on your definition of "risk free." Many investors use the 10-year Treasury as their benchmark. But as the Club's gurus have said many times over the last few years, you'd be crazy to buy a Treasury at today's rates. That's why I prefer to use something you'd actually own, like a CD or a money market fund. Either way... it's not a huge return, but unless something horrific happens, you won't lose money.
The math is simple, but you really don't need to know it. (There are free calculators online that do the work for you, or you can go here and create your own calculator using Excel.) All you need to know is how to interpret the results.
Typically, the higher the Sharpe ratio, the better. But the numbers are relative. The key is to compare figures between similar assets.
To keep things simple, let's look at the numbers for a few similar small cap mutual funds. Using my calculator, I get the following:
The results are all quite similar, but the T. Rowe Price fund stands out as a clear winner. With a Sharpe ratio of 1.22, it not only outperformed its peers over the last five years, but also offers a larger return with less risk than the overall market (as measured by the S&P 500).
There is no doubt a small cap fund will be more volatile than the broader market, but through the Sharpe ratio, it's clear that the T. Rowe Price fund more than compensates investors for the added risk.
As Steve not-so-gently suggests in his video, risk is in the eye of the beholder. Getting sucked into the day's headlines and letting emotions control your portfolio is flat-out dangerous.
The Sharpe ratio is one more tool informed investors use to overcome their emotions.
Good investing,
Andrew Snyder
Editorial Director, The Oxford Club
To access the Investment U archives, please visit InvestmentU.com.
Have "Two Cents"? Just send your thoughts, ideas or comments by clicking here.
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Keep a civil tongue.