The Official Blog of Retail Backtest
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Entries for date "July 2017"

Will the Real Sharpe Ratio Please Stand Up?

The basic idea of the Sharpe ratio or of any of it's cousins is to get a single number that is a sort of figure of merit for the performance of a portfolio— whether the portfolio is actively managed or not. And so that should involve not only a bigger figure of merit for better returns but also some sort of penalty being applied to the more volatile portfolios, volatility being not desired. The Sharpe ratio is a suitable figure of merit because it is a ratio of a measure of the return on an investment to a measure of its volatility. It therefore implies less merit when the volatility, the denominator, is large.

The question is exactly how do we compute the ratio... the details. This concern isn't only or particularly about whether or not a specific way of computing the ratio makes it into a more innately worthwhile figure of merit than another, as the various specifications of the ratio that have been put forward are not so very different in that regard; it's mainly about wanting to avoid taking an approach that hardly anyone else is using, for the sake of communicating results fairly to broad audiences. So what are others doing? What is William F. Sharpe doing? Incredibly, he's being vague about how his ratio should be computed— that's what he's doing. Read on!

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Statistics, and the Long-Term Return on Your Investments

There is this dismal applied science that is called "statistics". It's usually packaged together with "probability". So you take a course called "Probability and Statistics 101". And one of the very first things that you learn is that a statistic is a number whose value is derived from and is characteristic of a distribution of possible outcomes. The distribution defines the probabilities.


But, if you buy that fund, what is it most likely to be worth in 10 years? That's probably what you really want to know. Well you can't get that from the median of the annual return ratios over the past 10 years. You couldn't even get the answer to that particular question from the median of the next 10 annual return ratios if somehow you knew those in advance. Actually, unless the historical data were distributed in a particular way the historical median isn't even a statistic of interest. Others are and we'll get to them. Do read on. Today's entry is about the statistics on fund performance that are normally made available to you and how you can use them.

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