What’s in a Rank?

Oct 15th, 2007 | Filed under: Analytics and Metrics

Hello Cake Members,

My name is Manu Sharma, and I am the R&D Scientist at Cake Financial. It’s a fancy and intimidating title, I know, but what it means is that I work on the parts of Cake that involve a lot of math!

This is the first of a series of posts on Cake’s Analytics and Metrics. In this installment I will talk about the algorithm we use to rank Cake members, which I developed with our Architect, Sven Junkergård. The thing that makes Cake so unique is the fact that we have access to real historical data for our members and we can do some very exciting things with it. You’ll see more posts from me on that in the future!

Ranking is an essential element of the site and we have done a lot of work to make sure you can get insights into your performance and have comfort in looking at others’ profiles.

For those who want to read the ending first, here is Cake’s secret recipe for calculating your rank:

Your Rank Score = Risk Adjusted Return + Tenure (Investment History)

As you know by now, we have five Rankings for Cake members:

a. ELITE (The top 1% Cake members)
b. PLATINUM (2 – 10%)
c. GOLD (11 – 25%)
d. SILVER (26 – 50%)
e. BRONZE (Everyone else)

For those who are intrigued enough to read on, I will address the following in greater detail:

a. Why we rank you.
b. How you and the Cake community can benefit from that information.
c. The basic ingredients that go into your rank – your return adjusted for risk and your investment history available to us.
d. Why a “Bronze” ranking doesn’t mean the end of your investing career and how you can improve it.
e. Finally, I will elucidate in some detail how the ranking algorithm works in practice.

I. WHY WE RANK YOU AND WHAT IT MEANS

So, what does a rank on Cake really mean? Why do you receive a rank and how do we come up with it?

The purpose of ranking is twofold:

a. To give you insight into how you are doing with respect to other members, and
b. To give all Cake members the peace of mind that they are looking at an objective measure of performance derived from real, verified data.

Your rank is not simply based on how much return you made. We adjust your performance for several key factors: risk, the amount of history we have on you, and your tenure.

You can’t be considered an excellent investor if you have outperformed the market in your first month – you need to have some experience and consistency in your performance. That is why we give bonus points if you have done it consistently over time.

There is no absolute scale on which one individual or even a group of individuals will be the absolute best forever. Ranking by its very definition is relative. There are benchmarks, however, and these can be market indices, or other individuals. The point is that even if I as an individual have been outperforming the market with less risk (such people really do exist, by the way! See for example, this study by Harvard Business School professor Joshua D. Coval et. al.), there are others like me, and I can surely learn from them.

This allows me to realize a higher return for the current risk in my portfolio, or realize the same return at a reduced risk.

As you can see, your rank depends on several factors – your risk and your investment history. Some of these factors are in your control and some not. Getting a “Bronze” ranking is no cause for despair! You can improve it by lowering the risk in your portfolio, e.g., by diversifying your portfolio. Your tenure is another factor that affects your rank. As I explain below, if you have less than two years of investment history, your rank is scaled down. This means that if you continue to do well over time, you should see your rank improve steadily!

II. ALGORITHM DETAILS

Now that we’ve covered that, let’s take a closer look at how this is done.

The idea here is to be as quantitative as possible, so we would like to give each of our members a numerical score.

Your rank has three major ingredients:

a. Risk Adjusted Return: There are several ways to calculate a risk adjusted return and we are using something called a Sharpe Ratio. Loosely defined, the Sharpe Ratio is the amount of return per unit of risk. Think of it as the justification for taking risk – the higher your Sharpe Ratio is the more justified you are in taking the risk that you take.

We calculate a Sharpe Ratio for the last two years. This is as simple as taking your average monthly return for the last two years and dividing it by the risk. The risk in this case is nothing more than the standard deviation of the monthly returns, i.e., how much your monthly return varies from month to month. If you read the Wikipedia article above, you will notice that there is some complication around only including your return above the risk free rate. We do this as well but it does not change the basic calculation much.

Once we have a Sharpe Ratio, this is scaled by looking at the Sharpe Ratios of other users and translated into a risk adjusted return score that we use as the basic component of your rank.

b. Tenure: Tenure adjustment to your rank score is a way to differentiate consistently good investors from lucky investors in an up-market. If a user has more than two years of investment history (tenure), the rank score – as calculated above is left unchanged. If a user has less than two years worth of history, we use the tenure to adjust the score we got from the risk adjusted return downwards.

The final number is your total score. The top 1% of the members are then ranked Elite, the 2-10% are ranked Platinum, 11-25% Gold, 26-50% Silver and the remaining are ranked Bronze. Of course, we can’t rank you if you haven’t linked an account with us.

This algorithm ranks me as a Bronze investor… I may be good at developing a useful algorithm, but I guess I have some things to learn to be a good investor. That’s what I hope to learn from the Cake membership!

If you have any questions or thoughts on this, please send me an email at msharma@cakefinancial.com. Look forward to hearing from you.