As a high-frequency trader, my job was to create algorithms that would trade billions of dollars in stocks at microsecond speeds, capitalizing on tiny mathematical edges that would capture just fractions of a penny on each trade.
When I left the financial world to build my own business, I realized that the data-driven mindset ingrained in me from high-frequency trading was actually a huge benefit while running a business.
I also realized that there are a number of lessons that entrepreneurs could learn from finance–chief among them, the Sharpe Ratio.
If you’re running a business and your goal is to generate $10 million in revenue in the next two years, what would you like your revenue growth to look like?
Would you rather have a jagged line that goes up and down, with extreme swings in either direction until you miraculously hit $10 million? Or would you rather have a smooth and stable graph that slowly curves up to $8 million, even if it means coming short of your goal?
The answer is obvious. Stability is valuable when growing a business as it allows you to predict what’s going to happen next and plan accordingly. That’s why so many businesses are ready to provide a discount for subscriptions or upfront payments.
Unexpected profits might be nice, but if growth is inconsistent you may then be stuck in difficult positions where you’re unable to pay your team or make key decisions about what to do–because you have no idea what’s going to happen next.
At certain points while growing your business, you’ll likely be faced with a choice. Do you take a gamble on a risky move that has the potential for a high payout? Or do you play it safe and go for a more guaranteed (but lower) return?
While you might not be able to plug numbers into the Sharpe Ratio for these decisions, understanding the concept behind it is a fundamental mindset shift that can help you make the right decision.
Let’s step into the financial world for a second.
Everyone wants to find a low-risk investment that will yield a high return. The Sharpe Ratio is a calculation that helps investors, traders, and hedge fund managers do exactly that by comparing the return on an investment with its level of risk.
I’ll spare you the financial jargon by explaining how this works in plain English. Essentially, the Sharpe Ratio helps an investor answer the question: “Is this investment going to be worth it, given the level of risk I’m taking on?” It can also be used to review prior portfolio performance, indicating whether the investor made smart decisions or simply got lucky.
Playing roulette, for example, would have an incredibly low Sharpe Ratio as your expected return is negative and your profit is extremely volatile–even if you might get lucky sometimes and make a killing!
If you’re running a hedge fund, you can’t rely on getting lucky, but at the same time, you need to choose investments that will generate a consistently high return with minimal volatility. The higher the Sharpe Ratio, the higher the return you are getting for a given level of risk.
The brilliant part about all this is that entrepreneurs can apply the principles of the Sharpe Ratio to make better decisions about how to grow their business.
The idea is to ask yourself these three questions for every growth-related decision you make:
Answering these questions–even if they’re vague estimates–can help you formulate a rudimentary risk-adjusted return for business decisions. Here’s a simple example.
Say you have an idea for a high-ticket product to sell in your business. If it catches on, you could double your revenue. But if it doesn’t, you’ll have nothing to show for it and you’ve now wasted time and money which could’ve been spent generating a more guaranteed return.
Alternatively, you could invest that same time and money into selling and improving the product you already have with a near guaranteed growth of 80%.
Depending on where you are in your business and the level of risk you’re willing to accept, one might make more sense than the other. Think like a hedge fund manager–use the Sharpe Ratio to make the right decision!