Dow's Reward to Risk Ratio at Historic Levels
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This is Your Money Matters from The Wall Street Journal. Welcome to Your Money Matters. I'm J.R. Whalen with Anne-Marie Fertoli in New York. We've seen big gains in the Dow Jones Industrial so far in 2017 coupled with low volatility, and that sets up the potential for high reward for investors. How high? One measure of reward over risk puts the current Dow performance in rarefied historical air. And The Wall Street Journal's Chris Dietrich is here with us to explain. So, Chris, let's just for a moment take stock, no pun intended, of how well the Dow has performed this year.
Right. So the Dow, if you include dividends, is up nearly 19 percent this year. Over the past 12 months, it's up closer to 32 percent. So this tremendous rally that we've seen has really persisted on an almost like day in, day out basis where we've seen dozens and dozens of all time highs. That's something I think that anybody who pays attention in this space has known.
How unusually high has the Dow's performance been this year?
But what's particularly interesting is that it's occurred with this very low day-to-day volatility. And so if you think about pairing the two, it really means it's been a particularly and historically unusual easy ride for investors over the past year.
Chris, this particular measurement that you write about in your story in the Wall Street Journal is known as the Sharpe ratio. What exactly does that measure?
Yeah, the Sharpe ratio was created in the 60s by a Nobel laureate, and it's really a way to keep tabs on how much reward investors are getting relative to the risk that they take. So when a given stock or a mutual fund goes up a lot, but it shifts around, it's incredibly volatile, it might end the year up 100%, but it'll be down 50%. That's a very low Sharpe ratio, something that goes up a lot that has had very little volatility and therefore lower risk has a very high Sharpe ratio. And so we see now with the Dow is this incredibly high, higher than almost 100% of all readings since 1900. And all that means is it's been an incredibly easy ride for investors.
So all the readings this ratio has shown, and it shows reward over risk, it sits at a point where nearly all readings in the last 110 years don't come close to it. Is that what you're saying?
Yeah, don't come close to it. And we're just measuring it over the past year. And there's a lot of different time periods that you can measure something like a Sharpe ratio. So like over 15 years, the Sharpe ratio for the Dow was something like 0.7. Over the past year, it's many magnitudes higher than that. It's around 4.5. So it's just this really stark illustration of how unusual the markets have been recently.
And this really shows why investors, both individual and institutional, see the stock market as such a safe destination for their money.
Yeah. And keep in mind, that's very unusual, right? I mean, stocks are inherently risky. And traditional thinking is that the greater risk you take, the greater potential for reward and vice versa. That's why typically it makes sense to have a mixed portfolio of stocks and bonds. This past year, though, just owning stocks has been incredibly challenging. To the point that it admittedly worries many people that you can be lulled into complacency. Of course, owning stocks is risky. Of course, stocks can go down. And I think that's why this measure is so interesting over the past year. They simply have not gone down.
And Chris, to that point, and what you've pointed out as sort of ironic, is that this extremely low risk profile in stocks is actually coveted by more risky investments like hedge funds and endowments, right?
Right. So for decades, this is sort of the holy grail of investing and has been the aim of things like Yale's endowment or many hedge funds on the street is to get maximum return for very low risk investments. That's why things are diversified. That's what really hedge funds have tried to do. But in a funny way, this Dow Jones Industrial Average that's been around since before 1900 is almost acting as if it's the best sort of hedge fund of all.
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