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