AIM and the Sharpe Ratio
With AIM, we hope to realize two things for our investments: to reduce risk and to raise return. At least in our hopes, AIM is the Holy Grail of investing. How can we check this? Perhaps the Sharpe Ratio will give us some idea. The SR relates (excess) return to risk/volatility, and comes up with a number. A high number means relatively much return for relatively little risk. We could use this for a comparison between AIM and B&H, or for a comparison between AIMs.
To calculate the SR, we need the annualized return for an investment, its volatility, based on periodic checkups (I use monthly), and the risk free return. We leave the risk free return out for a moment.
Let us have a look at the Lichello cycle. This is a trivial case, as the B&H return is zero. Relating zero return to whatever else results in zero, so AIM wins if it can make a profit, and Lichello showed it can. But it is still interesting to look at the risk: in a spreadsheet with 40+ cycles, I calculated the Geometrical Standard Deviation to be 136% for B&H, and 89% for AIM. AIM's millions are gained with less risk. BTW, that 89% is still a lot of volatility.
Now for almost the opposite extreme: the SP500 index. The SP500 is a bit dubious as an AIM investment, as it has very little volatility. But couldn't the risk reducing factor still work wonders? B&H for the SP500 from Jan 79 through March 01 gives a return of 12.0% (I think this ignores dividends) and a volatility of 15.8%. The Return/Volatility ratio is then 0.756. A fairly BTB AIM with Safe settings of 5% both ways gives an annualized return of 9.2% and a volatility of 11.6%, wih a Return/Risk ratio of 0.792. So AIM has a better Return/Risk ratio, but that is not the same as the Sharpe Ratio. The SR uses Excess Return, defined as (annualized) Return - Risk free return. Usually, the 90 day Bond Rate is used for the RFR. I don't know that rate over this period, but 5% doesn't seem to be a bad guess. For B&H we then get (12-5)/15.8 = .44, for AIM we get (9.2-5)/11.6 = .36.
The conclusion should be that in the case of the S&P500 over the period Jan 79-Mar 01, the reduced return of the AIM version considered is not compensated by the reduced risk. You could have gotten a better return and a with AIM comparable risk by splitting your investment over the index and bonds.
So, maybe the SP500 is a bad target to AIM. Suggestions or analyses for other AIM targets are welcome. And your opinions about these calculations, of course.
Regards,
Karel
