Sharpe Ratio – the right answer to the wrong question?

TradingEdgeVisualiser

Sharpe was the right answer

First, let’s start with what Sharpe does well. There are two things it does well:

  1. Cross-asset unified measure: we all know that the most important component in alpha generation is asset allocation. Now, the difficulty is to have a single measure of risk-adjusted measure of alpha. This is where Sharpe did the job. It could give a single number across many asset classes: be it fixed income, equities, commodities, etc.
  2. Uncertainty: the human brain is hard-wired to associate uncertainty with risk. It triggers the amygdala and activates the fight, flight or freeze reflex (see one of my posts about fear and greed). So, Sharpe is a good measure of uncertainty: it quantifies units of uncertainty-adjusted performance.

Now, Sharpe ratio, as part of the modern finance package, was invented the same year of the coronation of the Queen of England. It was good, almost revolutionary for its time, since Batista in Cuba was fighting El Che and Fidel. But, like the UN building designed by Brasilian Oscar Niemeyer, it did not age well, and here is why:

Sharpe is not a measure of risk, it is a measure of volatility-adjusted performance

It associated volatility with risk. Risk does not equate volatility and here are a few examples:

  1. Low vol may be extremely risky: LTCM had low vol. In fact, their strategy was to be short gamma. It worked until it did not. Fast forward to 2008, vol funds collapsed one after the other. Low vol does not equate risk.
  2. CTAs like Ed Seykota, Tom Basso, Bill Dunn, William Eckhardt, etc: they have supposedly hopelessly low Sharpe but have clocked >+25% year in year out.

Does it mean that the CTAs have risky strategies ? No, it means they have low semi-volatility-adjusted strategies. Semi-vol is just downside volatility.

Risk means uncertainty, just learn to get comfortable with it

As much as I understand that uncertainty is not pleasant and may trigger some reptilian alarms in our brain, we must learn to live with it. It involves mindfulness meditation, strict formalisation of strategies, etc. Do not pray for an easy life, pray for the strength to endure a tough one.

Now, what is risk ?

Risk is not a paragraph at the end of a dissertation. Risk is a number. The only difficulty is to find the adequate formula that goes along. There are two types of strategies: mean reversion or trend following. Please read my posts on the subject.

Risk is not difficult to quantify. It is only difficult to identify. I have come up with the common sense ratio as it recaptures both mean reversion and trend following strategies.

CSR = tail ratio * gain to pain ratio

Please use the trading edge visualiser to find out your personality:

TradingEdgeVisualiser - Sharpe Ratio

Conclusion

Bottom line, we have associated risk with volatility. We have come up with a measure of volatility-adjusted performance and deem it a risk measure. CSR, on the other hand, is a unified risk measure that can be used across asset classes. It measures risk according to strategy type.

Get in touch to Download files, resources, and some materials to take the advantage.

— By Laurent Bernut of Alpha Secure Capital originally appeared at Better System Trader.

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  • Peter says:

    From the referenced website:

    “Trading Edge = Win% * Avg Win – Loss% * Avg Loss”

    This has nothing to do with the edge. Is an average weight of 5 Kgs always potatoes?

    Why are you posting such articles people? You have no respect for other peoples intellect?

    • Laurent says:

      Hello Peter,

      I am the author of the above post. first of all Merry Christmas.

      I am honored to see that a simple post has traveled so far. It was originally something I said on Andrew Swanscott’s podcast Better System Trader episode 32. An attentive listener picked it up. Andrew liked the answer and decided to post it and then it got reposted on this prestigious website. I am truly honored and grateful. Thank You.

      Now, would You agree that what you stand to gain depends on 1. how often You win and 2. How much You win less 3. how often You lose times 4. how much You lose ?

      This is called gain expectancy. Any probabilistic system, whether it is gambling, trading, or any other probabilistic endeavour can be summarised by its gain expectancy. Gain expectancy features in any introductory course on probabilities. So, I apologise for my lack of originality.

      Now, the entire game of trading is about tilting gain expectancy. There are three ways it can be achieved:
      1. Increase win rate: scale-out or take profit
      2. Decrease Avg Loss: Stop Loss and better exit policy
      3. Elongate Avg win distribution: scale-in or run winners

      Peter, I would encourage You to download the trading visualiser tool. It literally changed the way I approach markets. This is a tool i use every time i work on a strategy.
      And yes, I make no apologies for renaming gain expectancy trading edge.

      Merry Christmas

  • JJ says:

    I think volatility is a great measure of risk in most day to day cases but it doesn’t address the underlying issue. I tend to think of risk as the likelihood that I’m gonna lose a lot of money in an investment. High volatility simply implies that the security has endured a ton of price fluctuations in the past which has caused some investors to lose a ton of money.

    So high volatility implies high risk. But the converse isn’t always true. Just because something is observed to have low volatility doesn’t mean it’s safe. Volatility is a backward looking measure.

    Sharpe ratio is also a backward looking measure as well although it’s the gold standard in the industry. The observed return, the risk free return, and the volatility are all variables that are not going to stay the same going forward so it’s merely a measure of how the investment performed in the past, not its merits going forward.

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