Sharpe Allocator Guide

The Sharpe Allocator offers a different way of looking at allocations within a portfolio. The benefits of this tool are in its simplicity. Because it is not a pure mathematical optimizer in the sense of the Efficient Frontier, it often generates less extreme recommendations. It is based on the Sharpe Ratio, designed by noble prize winner Bill Sharpe. The Sharpe Ratio is a measure that provides a “score” indicating how a particular investment is performing. The performance is measured as a ratio of reward to risk, as follows:

The higher the Sharpe Ratio, the better, since it means that the investment is offering a high rate of return relative to its risk, as measured by standard deviation, an indicator of volatility.

The Sharpe Allocator calculates the past Sharpe Ratio for each security in the portfolio and then sums these ratios for a total score. The tool then weights each security in proportion to its contribution to the total score. Let’s take an example. Suppose there are two securities in a portfolio, A and B. Assume asset A has a historical Sharpe Ratio of 2.0, and asset B has a one of 4.0. The sum of Sharpe Ratios is then 6.0. The resulting asset weight for asset A will then be 33.3% (2.0/6.0), and the resulting weight for asset B will then be 66.7% (4.0/6.0). So the overall concept is very simple. The higher the Sharpe Ratio for a particular asset, the higher its proportion will be in the final portfolio.

Be aware that the Sharpe Allocator does not consider correlations between assets, an important consideration in portfolio diversification. And it does not seek to maximize the overall portfolio Sharpe Ratio based on the total portfolio return and volatility. So do not use this tool in isolation. You should also use the Correlation Analysis or the Efficient Frontier, since these tools provide a good idea of the level of diversification in your portfolio that will help to reduce risk.

To use the Sharpe Allocator to analyze a portfolio, perform the following steps:

Select the Sharpe Allocator tool.
Add your securities to the list of portfolios, either by selecting the security in the asset selection tree, or by using the search feature. Select the “Add” button or “Remove” button to add or remove each security from the list.
Once you have added the securities, select the “Next” button.
Select the time range to analyze historical data for the analysis. It is important to select a time range long enough to provide a good representation of stock price movements under different market conditions (up and down).
Enter the risk-free interest rate. This is the rate it which you could invest your cash with no risk. The 10-year treasury rate is often used here.
If you want to specify an allowed range for any individual security in the portfolio, you can enter minimum and maximum allowed weights for any specific security. If you specify these, the tool will adjust its calculated theoretical optimal portfolio (which may have weights outside your desired range) to fit within your specified limits. The resulting portfolio will be reported as the Adjusted Portfolio.
Select the “Calculate” button.
At this point, the tool will calculate the results which are reported in two tables:

Name	Symbol	Expected Return (Er)	Standard Deviation (StDev)	Optimal Weight	Adjusted Weight	Sharpe Ratio
ISHARE MSCI AUSTRIA	EWO	18.4 %	15.8 %	37.1 %	37.1 %	0.91
iShares S&P 500	IVV	10.1 %	6.8 %	35.7 %	35.7 %	0.87
Vanguard Emerging Markets ETF	VWO	18.6 %	21.6 %	27.3 %	27.3 %	0.67

Metrics for Above Portfolio Mixes
Name	Annual Return (Er)	Annual Standard Deviation (StDev)	Sharpe Ratio	Er/StDev Ratio
Optimal Portfolio	15.4 %	12.9 %	0.88	1.20
Adjusted Portfolio	15.4 %	12.9 %	0.88	1.20

The first table shows each asset in the portfolio and its characteristics, including:

· Expected return – the expected annual return based on the asset’s mean return over the historical time period you selected.

· Standard deviation – the standard deviation of the asset over the time period you selected.

· Optimal Weight – the calculated weight of the security based on its Sharpe Ratio contribution to the total sum of Sharpe Ratios.

· Adjusted Weight – the calculated weight of the security that adjusts the optimal weight to fit within the allowable range specified by you.

There are two portfolios shown. The overall characteristics of each portfolio are shown in the second table. This table shows the expected annual return and standard deviation for each of the three portfolios.

It is important to study and understand the tables. Some key points to look for:

At this point, you may want to make adjustments to your portfolio by going back to the first page of the Sharpe Allocator and removing or adding assets to see how they contribute to your portfolio. You can experiment with a virtually unlimited variety of portfolios.

Be aware that the Sharpe Allocator does not attempt to reduce the overall portfolio variability in any way since it does not take into account correlations between individual securities. Therefore, do not use this tool in isolation. You should also use the Correlation Analysis and Efficient Frontier on your security to see how the results compare and to achieve better diversification.

Finally, be aware that all results of the Sharpe Allocator tool are based on past price history behavior of each security, and that past history is often not an indicator of future behavior. Market conditions can change, as can managers of mutual funds and companies. This is why it is important to select a time period for analysis that you feel will be a good representation or model for the future. It is also why it is essential that you carefully research each individual security on its own merits to understand its prospects for the future.

Once you are done building and analyzing your portfolio, you can choose to save it if you wish. To do this, select the “Save portfolio” button. If you are not already logged-in, you will be prompted to log-in so that the portfolio can be associated with your user-name. You can later reference this portfolio in My Portfolios, and track its history or perform further analysis in the future.

Using the Sharpe Allocator