Roy's Safety-First Criterion (SFRatio)

What Is Roy's Safety-First Criterion - SFRatio?

Roy's safety-first criterion, otherwise called the SFRatio, is an approach to investment decisions that sets a base required return for a given level of risk. Roy's safety-first criterion permits investors to look at potential portfolio investments in view of the likelihood that the portfolio returns will fall below their base wanted return threshold.

The Formula for the SFRatio Is

$\begin &SFRatio = \frac{\sigma_p}\ &\textbf\ &r_e = \text\ &r_m = \text{Investor's minimum required return}\ &\sigma_p = \text\ \end$

Instructions to Calculate Roy's Safety-First Criterion - SFRatio

The SFRatio is calculated by deducting the base wanted return from the expected return of a portfolio and separating the outcome by the standard deviation of portfolio returns. The optimal portfolio will be the one that limits the likelihood that the portfolio's return will fall below a threshold level.

What Does Roy's Safety-First Criterion Tell You?

The SFRatio gives a likelihood of getting a minimum-required return on a portfolio. An investor's optimal decision is to pick the portfolio with the highest SFRatio. Investors can utilize the formula to ascertain and assess different situations including different resource class loads, various investments and different factors that influence the likelihood of meeting their base return threshold.

A few investors feel that Roy's safety-first criterion is a risk-the board philosophy as well as being an evaluation method. By picking investments that stick to a base acceptable portfolio return, an investor can rest at night realizing that her investment will accomplish a base return, and anything over that is "sauce."

The SFRatio is basically the same as the Sharpe ratio; for ordinarily distributed returns, the base return is equivalent to the risk-free rate.

• Roy's safety-first rule measures the base return threshold an investor has for a portfolio.
• Otherwise called the SFRatio, investors can utilize the formula to contrast different investing situations with pick the one probably going to hit their required least return.

Illustration of Roy's Safety-First Criterion

Accept three portfolios with different expected returns and standard deviations. Portfolio A has an expected return of 12% with a standard deviation of 20%. Portfolio B has an expected return of 10% with a standard deviation of 10%. Portfolio C has an expected return of 8% with a standard deviation of 5%. The threshold return for the investor is 5%.

Which portfolio should the investor pick? SFRatio for A: (12 - 5)/20 = 0.35; B: (10 - 5)/10 = 0.50; C: (8 - 5)/5 = 0.60. Portfolio C has the highest SFRatio and in this way ought to be chosen.