The 3 Musketeers of Risk Analysis

1 set 2023

Introduction:
In the world of investing, managing risk is as crucial as seeking returns. Three vital tools for assessing risk-adjusted returns are the Sharpe Ratio, Sortino Ratio, and Omega Ratio. In this post, we'll explore these ratios, their calculation, their unique features, and when to use them.

1. Sharpe Ratio: Balancing Risk and Return

• Measures risk-adjusted returns using total volatility (both up and down).
  
• Formula: (Return - Risk-Free Rate) / Portfolio Standard Deviation.
  
• Strength: Widely accepted and provides a simple assessment of risk-adjusted return.
  
• Weakness: Assumes normal distribution and ignores skewness.
  

2. Sortino Ratio: Focusing on Downside Risk

• Emphasizes downside risk.
  
• Formula: (Return - Risk-Free Rate) / Downside Deviation (only negative returns).
  
• Strength: Ideal for risk-averse investors and non-normally distributed returns.
  
• Weakness: Ignores upside volatility.
  

3. Omega Ratio: Probability of Positive Returns

• Evaluates risk-adjusted returns based on the probability of achieving positive returns.
  
• Formula: Probability of Positive Returns / Probability of Negative Returns.
  
• Strength: Provides insights into return probabilities and considers tail events.
  
• Weakness: Less recognized and may require more data.
  

Conclusion:
Understanding these ratios helps investors make informed decisions. The Sharpe Ratio simplifies risk-return assessment, the Sortino Ratio prioritizes downside protection, and the Omega Ratio analyzes return probabilities. Combining these ratios offers a comprehensive view of investment performance in an unpredictable financial world.