One possible complaint about income investments somebody could have is that there is no technical indicator of what risks are associated with them.
Capital Gains Investors Should Use the Sharpe Ratio
People who invest for the market price to go up, face the risk it will go down. This is measured by the Sharpe Ratio, after its inventor William Sharpe.
The Sharpe ratio compares the amount a financial security goes up in comparison to its "risk" -- defined as short term price variability.
This is a way of measuring whether a security is worth investing in. If the risk it will go down in price is greater than how much it could go up in price, then it's a bad deal.
Think of it as a comparison to the dice game craps where you bet the next roll of the dice will come up two sixes -- 12 -- boxcars.
Because the two dice have a total of thirty-six possible combinations, and two sixs is only one of those possibilities, the odds of boxcars coming up is 1 out of every 36 rolls of the dice.
If the casino paid you $37 for every boxcar bet, that'd be the best bet available in the casino. That's because the casino would be rewarding you with more money than the mathematical odds call for.
Smart gamblers would do nothing all night but make this bet. Sure, they'd lose an average of 35 out of every 36 rolls. But when they won, they'd win more than enough money to make up for their losses.
If they paid $36 for the boxcar bet, it'd be a break even result. (And therefore would still be the best bet in the casino!)
However, in real life casinos pay $30 to winners of that bet, which is not enough to fully compensate them for the risk they took. That's why casinos have lots of money and gamblers don't.
If Your Reward Is Lower Than Your Risk, That's a Bad Investing Bet
The Sharpe Ratio applies the same concept to financial securities. However, the odds are determined by historical price volatility, which is one usually unacknowledged limitation of conventional finance and investing.
Still, it's useful to look at, especially when somebody brags about their or their financial adviser's performance. When somebody claims they've outperformed the market, they've probably done so by taking too big of a risk to justify what they received.
What's the Risk Our Income Will Go Down or Stop?
However, with income investing we're not concerned with short term market price volatility. We want to receive a stream of income in the future.
For the income investment of bonds, the obvious thing to do is to look at credit quality. I recommend you not buy any bond, bond fund or bond ETF under investment quality.
Stock dividends are much more difficult. Unlike with bond interest, companies do not guarantee they will pay any dividends in the future, let alone increase what they're paying now.
Essentially, stock dividends depend on business performance -- now and in the future. That can't be known with certainty.
Fortunately, the kinds of companies that pay dividends in the first place tend to be older, well established, and with products proven in the marketplace. Therefore, there's less risk they will lose money in the future.
Therefore, income investments are less risky than so-called growth stocks. They are in time-tested businesses.
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