tag:blogger.com,1999:blog-706772597530050449.post3852923414071733029..comments2023-03-15T06:41:18.112-04:00Comments on Reading the Markets: Risk tolerance and the Sharpe ratioBrenda Jubinhttp://www.blogger.com/profile/02587551531260863509noreply@blogger.comBlogger2125tag:blogger.com,1999:blog-706772597530050449.post-47340875707543750552009-11-18T11:00:30.406-05:002009-11-18T11:00:30.406-05:00Jorge,
I know some of the standard criticisms of ...Jorge,<br /><br />I know some of the standard criticisms of the Sharpe ratio; in fact, in this comment I’ll even excerpt two and give a url for another. But for me at least seeing a visual of wildly varying risk situations that have identical expected values and variances was a stunner.<br /><br />And now for the pedantry:<br /> “Although it is essential to consider fund returns in the context of fund risks, the Sharpe ratio is a bit of a blunt instrument to measure risk-adjusted returns. Past returns don't predict future returns. And although relative risks among funds have a good deal of consistency over time, standard deviation is only a rough proxy for a concept as elusive as risk. Further, weighting risk as equal to return in importance in the formula is completely arbitrary. Here is the reality of investing, as I see it: An extra percentage point of standard deviation is meaningless, but an extra percentage point of return is priceless. Large differences in risk are extremely important - there is a difference between a stock portfolio and a bond portfolio - but the expedient of weighing risk and return equally, in a simple formula, leaves much to be desired. In the final analysis, risk-adjusted returns, like beauty, may be in the eye of the beholder.” (John C. Bogle, <em>Common Sense on Mutual Funds,</em> p. 150)<br /><br />“The issue here is that the Sharpe ratio is only appropriate for ranking investment/trading alternatives whose performance is completely defined by the first two moments of the distribution. If some alternatives have skew or kurtosis (but identical mean and S.Dev.), then Sharpe ratio won't distinguish among them. Yet most economic agents would prefer positive skew and low kurtosis. I'm sure you could extend the Sharp ratio concept to additional moments using analogous arguments of a tangent figure between the risk-free alternative and the multidimensional efficient frontier on the space of moments”. (post on Wilmott Forums)<br /><br />And finally, “A Critique of the Sharpe Ratio” by David Harding, Winton Capital Management (http://www.edge-fund.com/Hard02.pdf).<br /><br />Thanks for your comment. You always stretch my mind.<br /><br />Best,<br />BrendaBrenda Jubinhttps://www.blogger.com/profile/02587551531260863509noreply@blogger.comtag:blogger.com,1999:blog-706772597530050449.post-2608413323533896452009-11-18T08:41:15.460-05:002009-11-18T08:41:15.460-05:00Hi Brenda,
Yes, giving equal weight to the varian...Hi Brenda,<br /><br />Yes, giving equal weight to the variance of both profits and losses is one of the problems of the Sharpe ratio. Although, I'm sure you will soon discuss additional methods, Kaufman discusses better ways to measure risk/reward in New Trading Systems and Methods (including the - literally - Ulcer Index, Var, Schwager's average maximum retracement etc.).<br /><br />Also, Curtis Faith, in his - in my opinion - not-so-great Way of the Turtle, has a couple of worthwhile chapters on risk/reward measures, including his R-cubed.<br /><br />Thank you for keeping up the blog. Best trading,<br /><br />JorgeJorgehttps://www.blogger.com/profile/16875726059248008250noreply@blogger.com