💡 Bitcoin and Risk-Adjusted Returns

Issue 169

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Today’s Bullets:

• Sharpe Ratio Explained (Simply!)

• A Word on Volatility

• Bitcoin’s Sharpe Ratio

• Bitcoin Enhanced Portfolios

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Inspirational Tweet:

Risk adjusted return. You hear this phrase used by investment experts all the time, but what exactly does it mean?

And what’s this so-called Sharpe Ratio that often gets quoted alongside this risk-adjusted idea? And finally, how does Bitcoin, the ultimate-volatility asset, fit into the concept and calculation?

All good and super important questions that we will answer right here today, nice and easy as always.

So, pour yourself a big cup of coffee, and settle into you favorite Sunday chair for a peek behind the risk-calculation curtain with today’s Informationist.

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🤓 Sharpe Ratio Explained (Simply!)

Let’s dive right into the deep end today and unpack what is called the Sharpe Ratio, shall we?

Don’t be scared. It’s not actually that complicated, it’s just a calculation of a simple concept.

A little history first.

The Sharpe Ratio was created by Nobel Prize-winning economist William F. Sharpe in 1966, and it remains one of the most important tools in finance.

Why?

Because it offers a single, elegant number that helps answer a critical question for any investor: Am I being paid enough for the risk I’m taking?

At its core, the Sharpe Ratio measures the risk-adjusted return of an asset or portfolio. That means it doesn’t just tell you how much something went up — it tells you how difficult (read: risky) the path was to get there.

And if you’re managing billions of dollars in pension assets or even your own hard-earned money, the journey often matters as much as the ultimate outcome, or return.

Sharpe originally developed this ratio to guide portfolio construction under modern portfolio theory. The idea was that investors aren’t just chasing returns; they want efficient portfolios, or the most return per unit of risk.

And soon, the Sharpe Ratio became the go-to metric to rank assets or funds by their efficiency.

It pretty much revolutionized the way investment managers think about portfolios, and instead of just asking, What can I make?, they began asking, What do I have to endure to make it?

The Math: Sharpe Ratio Formula

Sharpe Ratio = (Rp − Rf) / σp

Uhm…what?

OK, let’s unpack the jargon of the formula. Simple, really.

Let’s assume you are calculating the Sharpe Ratio for a portfolio:

• Rp is just the expected or actual return of the portfolio

• Rf is the current risk-free rate (often just the current yield of 3-month US Treasury T-bills)

• and σp is the standard deviation of portfolio returns (how much volatility is in the portfolio)

So, you are just subtracting the risk free rate from the return of your portfolio to see how well the portfolio performed above the rate you can get with (supposedly 🤡) zero risk.

*Note: if you have been following me, you understand that there is no true risk-free bond in the world, but that is a discussion for a different time. For today, we will pretend there is such a thing.

OK, so then we just divide that extra performance by the volatility to get the Sharpe Ratio.

For instance:

Let’s say your portfolio returned 12%, the risk-free rate was 2.2%, and your volatility was 14%. Plug it all in:

(12 − 2.2) / 14 = 0.7

That means for every unit of risk you took, you earned 0.70 units of return beyond what you could get risk-free. It’s a way to quantify return per unit of pain.

Generally:

• < 0.5: Subpar

• 0.5–1.0: Decent risk-adjusted return

• > 1.0: Strong

• > 2.0: Exceptional (usually requires uncorrelated alpha or long-term edge)

Sharpe in the Real World: Why Institutions Obsess Over It

Sharpe Ratios aren’t just an academic exercise—they are core metrics in institutional finance.

• Pension funds and endowments use them to evaluate investment managers. If you’re running a global macro fund for Yale or CalPERS, you’re getting benchmarked on Sharpe

• Hedge fund allocators screen for Sharpe Ratios of 0.8 or higher. Anything below 0.5 and you’re usually cut from the shortlist — even if your nominal return was great

• Multi-manager platforms (like Millennium or Point72) are constantly analyzing internal Portfolio Managers (PMs) and their books’ Sharpe Ratios, adjusting allocations accordingly

A higher Sharpe Ratio tells them the risk was worth it and that the strategy is replicable. This is absolutely critical when deciding to allocate hundreds of millions or billions of dollars.

What It Looks Like in Practice

I will be referencing the following table a few times here today. Called the Nakamoto Portfolio (www.nakamotoportfolio.com) it shows various metrics from the classic 60/40 stock/bond portfolio over the last ten years, and then it includes Bitcoin as an additional asset to add to the portfolio.

Let’s key in on the Sharpe Ratios of the three assets.

What do we notice?

First, we see the original 60/40 portfolio (SPY + BND) had a Sharpe Ratio of 0.39 over the last 10 years — a relatively low risk-adjusted return.

• SPY alone: 0.53

• BND: -0.65 (negative Sharpe due to poor returns and low rates)

• and Bitcoin (BTC): 1.07 — the highest Sharpe of the group

That last one surprises most people, as Bitcoin is super volatile and therefore deemed super risky.

But despite Bitcoin’s massive volatility, its explosive long-term return more than compensates for it.

That’s the point of Sharpe: it doesn't penalize volatility — it penalizes volatility that isn’t rewarded.

In essence, the Sharpe Ratio helps investors avoid the trap of blindly chasing high returns.

For example, a meme stock might be up 200% one year — but if it’s also down 90% the next, its Sharpe could be zero or negative. Consistency matters. This is why capital flows to high-Sharpe assets over time.

About volatility…

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🫣 A Word on Volatility

Volatility has a branding problem.

To the average investor, it means danger, but to professionals, it often means opportunity.

In its purest form, volatility is just a measure of dispersion — how much returns deviate from their average.

It’s usually expressed as standard deviation, and it’s the backbone of nearly every financial model:

• Black-Scholes options pricing

• Risk parity frameworks

• Value at Risk (VaR)

• Monte Carlo simulations

But importantly: volatility is not always risk — at least not in the way that matters to investors’ goals.

Risk vs. Volatility

Real “risk” is permanent capital loss or failing to meet your objective (retirement, endowment payout, pension liability matching).

Volatility is just how circuitous the path is on the road to that outcome. Sometimes those diversions are the price of superior returns.

Let’s take Bitcoin as an example, see how it stacks up: