Understanding How Investment Risks and the Sharpe Ratio Affect Business Valuations

Next time you hear somebody talking about the returns you're making in the market, ask them this question, "What is the Sharpe ratio?" And see what they say.

Because when I talk to someone, they tell me they're making 15%, or 20%, or 30% in the market, I say, "What is the risk of that investment?" And they look at me with a blank stare because it's really not what you're earning, it's the risk you take to earn that.

For example, if I told you I had a bio startup company that had a new product and was going to earn 15% next year or you could invest in the S&P 500 index and make 15%, which would you choose?

You'd choose the S&P 500 because it's 500 companies, obviously, right? And biotech is very, very risky. And that's why when someone talks about what they're making, you have to be able to quantify it. And that's what the Sharpe ratio does.

It's a formula that uses the standard deviation of the investment to calculate the risk.

Because that's really what I'm concerned about. And I'm not only concerned about the return, what's the risk to get that return is important because if the risk is substantial, there's a very, very good chance that you're not going to get that return. And why would I take a risk if the risk, for example, the S&P 500 is far less than biotech, it doesn't make sense.

So one of the things you need to do is understand the risk of your investments. If you have any questions, feel free to give me an email.