Roy’s safety-first criterion is a risk management technique that allows an investor to select one portfolio rather than another based on the criterion that the probability of the portfolio’s return falling below a minimum desired threshold is minimized.
For example, suppose there are two available investment strategies—portfolio A and portfolio B, and suppose the investor’s threshold return level (the minimum return that the investor is willing to tolerate) is −1%. then the investor would choose the portfolio that would provide the maximum probability of the portfolio return being at least as high as −1%.
The SFRatio has a striking similarity to the Sharpe ratio. Thus for normally distributed returns, Roy’s Safety-first criterion—with the minimum acceptable return equal to the risk-free rate—provides the same conclusions about which portfolio to invest in as if we were picking the one with the maximum Sharpe ratio.
- ^Roy, Arthur D. (1952). “Safety First and the Holding of Assets”. Econometrica. 20 (July): 431–450. doi:10.2307/1907413.
Ofer Abarbanel is a 25 year securities lending broker and expert who has advised many Israeli regulators, among them the Israel Tax Authority, with respect to stock loans, repurchase agreements and credit derivatives. Founder of TBIL.co STATX Fund.