negative sharpe ratio This is a topic that many people are looking for. thetruthaboutdow.org is a channel providing useful information about learning, life, digital marketing and online courses …. it will help you have an overview and solid multi-faceted knowledge . Today, thetruthaboutdow.org would like to introduce to you The Sharpe Ratio – Risk Adjusted Return Series – Part 1. Following along are instructions in the video below:
“Investment performance is being discussed whether that be through the financial media. Other fund managers managers in financial blogs. Or comment. Sections on seeking alpha twitter for example.
You ll see performance being discussed in terms of a percentage return x. Percent. Compound annual growth rate. It sounds good on the surface.
And it s certainly good from a marketing perspective. Because it does get people interested oh how can i make that much money or by this fund. Because it made ten percent and that one only made five percent. But the problem is that annual return by itself says very little about how it was actually achieved was it due to investing skill or was it simply the result of excessive risk.
Maybe. Some added leverage or perhaps. Just the simple result of a bull market. So what should concern us.
Most is how consistent it was and how reliable it might be going forward the only way to know that is to actually measure. What s called the risk adjusted return. So today. In part one of this five part video series on risk adjusted return metrics.
I m going to introduce the most common and fortunately for us. The easiest method to try to answer some of those questions. And it s called the sharpe ratio..
So let s just dive into a simple breakdown of the sharpe ratio formula and before you click away because i know there s some people out there that absolutely cringe when they see math formulas for me growing up in school. It was always english when i hear shakespeare. I m just tuning out i m a math geek. And i know there s some people out.
There. That have the same reaction when they see math formulas. But bear with me. I ll keep it simple.
So inside that box is a simplified formula on the top also called the numerator. We ve got the return oftentimes referred to as the compound annual growth rate. We take that and minus a risk free rate of return for that one we usually just use the us treasury rate for the same time period. In this case for simplicity.
We ll just say it s 1 then we divide that result by the annual risk. This is the standard deviation of the performance and since it s on the bottom of the equation. The denominator if this number gets bigger. Which would mean.
It s more inconsistent for month to month. It makes the overall sharpe ratio smaller so in this simple example a 13 percent annual rate of return minus the 1 risk free rate divided by a 12 percent annual risk and we ve got a sharpe ratio of 1. Now what does that mean well any sharpe ratio that s above zero. Means that you may be better off with the fund rather than the risk free rate.
A sharpe ratio below zero means that you may be better off with the risk free rate in this case. Us treasuries and for context. A sharpe ratio of around one like we see in this example..
That s pretty good that s a fairly consistent performer. A sharpe ratio near two that would be exceptional especially when stretched out over several years but essentially from a risk adjusted perspective the higher the sharpe ratio. Number the better so that s what it means to measure return in terms of risk. The only way to increase your sharpe ratio is to increase your return more than your increasing your risk basically increase.
The numerator faster in relation to the denominator and therein lies. The problem for most investors. Because the truth is it s not actually that difficult to increase your rate of return especially in a bull market. But not doing it at the expense of also increasing your risk.
Which essentially means you might actually just give it all back when the markets don t cooperate. That s a real trick. And this is the power of the sharpe ratio. It gives us another level.
Another input variable to help us assess the long term viability of a strategy of course. It s not the whole picture. Yet that s why this is a five part video series. But it s a good first step.
So now let s take a look at a real example. These are the actual results of two exchange traded products since november 30th of 2010. The first is the spy. Which is an etf that tracks the s p 500 index and the second is the xiv which is an inverse volatility etm the xiv has gained a lot of popularity over the last few years because of its high rate of return since it launched in november of 2010.
Remember that s absolute performance just the rate of return. We ll see in a minute if it s still a good risk adjusted performer. But looking at these two products which one is better most people would immediately say the xiv of..
Course right nearly three times the return. 379 compared to just 137. For the s p 500. This is no contest.
But when we factor in the annual risk. Which is the standard deviation of those month to month returns. It s not so clear anymore. The xiv has a higher return.
There s no doubt about that. But it s also way more inconsistent now with the sharpe ratio calculated. We seem to have our answer remember the higher the number the better so while the s p. 500.
Didn t perform as well on an absolute measure. It s being far more consistent and in the long run. It may be the better risk adjusted investment. But some of you may still be wondering why does this matter.
If the return is bigger in the end who cares how it got there right well if you start flipping a coin. Most of the time you ll notice that it alternates pretty regularly between heads and tails. You know you might get a streak of two or three in a row. Two heads three tails.
But it basically bounces back and forth. But if you continue flipping that coin eventually you re going to get a streak that hits six or seven times in a row. Maybe more investment returns and the xiv in this case is the same in a shorter time frame..
Those large month to month. Standard deviations may not be that detrimental especially since it s been a bull market its entire life cycle. It launched in late 2010. So it s never seen a bear market stocks have had a few periods where they dropped and the xiv did suffer major draw downs.
When that happened the largest being 74. But it s still a bull market so buyers come in they buy the dip stocks go back up and the xiv averts disaster. But on a long enough time horizon those massive monthly standard deviations and losing months have a higher probability of stringing together like six or seven coin flips will at some point. And when that happens the true long term rate of return reveals itself.
When you combine a bull market and a bear market together those low risk adjusted performers like a buy and hold on the xiv for example they can t avert disaster forever so hopefully that expands our toolbox a little bit when it comes to analyzing performance. It s just not good enough to look at a rate of return by itself we need to measure that in terms of risk. We need to see how consistent it was and that together should give us some clues as to how sustainable it might be in the long run in the next video. I m going to introduce another risk adjusted metric called the ulcer performance index it s got a very cool name and in my opinion.
It s even better than the sharpe ratio. So stay tuned for part 2. See you next time so go ahead and click the link right here sign up for the bts newsletter and when you do you re going to get full access to all three of my trading strategies for a full two weeks. Absolutely free and if you are new here.
Please consider subscribing to my channel also if you have any questions or comments. I d love to hear from you so go ahead and leave those in the comments. ” ..
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