What is the 'Roy's Safety-First Criterion - SFRatio'
An approach to investment decisions that sets a minimum required return for a given level of risk. The Roy's safety-first criterion allows portfolios to be compared based on the probability that their returns will fall below this minimum desired threshold. It is calculated by subtracting the minimum desired return from the expected return of the portfolio and dividing the result by the standard deviation of portfolio returns. The optimal portfolio will be the one that minimizes the probability that the portfolio's return will fall below a threshold level.
Also known as the "SFRatio".
BREAKING DOWN 'Roy's Safety-First Criterion - SFRatio'
The safety-first ratio is calculated as:
= E(r) - Threshold Return
The optimal decision is to choose the portfolio with the highest SFRatio. The SFRatio is very similar to the Sharpe ratio; for normally distributed returns, when the minimum return is equal to the risk free rate this will provide the same conclusions as if we were to pick the return with the maximum Sharpe ratio. The SFRatio is commonly found in financial courses and certificates, such as the CFA Level I material.