Headline:
Harmonizing High Absolute Returns + High Sharpe Ratio.
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All Professional L/S Money Managers Desire To Maximize Absolute Investment/Trading Returns.
However…2 Critical Factors Escape Many =
1. The Quantified Risk Required To Obtain Returns…
Which Is Particularly Tricky…As Risk Can Only Be Precisely Measured In Hindsight…
+
2. The Time Period Required To Generate Returns…
As Extremely Lengthy Holding Periods Can Offer Broad + Challenging Portfolio Implications…Such As Decreasing Return Per/Increment Of Time.
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Further…These 2 Crucial Features …Risk + Time…Provide The Cornerstone For…
The Most Supreme…Yet Under-Appreciated…Return Metric =
SHARPE RATIO.
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The Sharpe Ratio Is Nothing More Than A Simple Quotient…
Absolute Return – Risk Free Return / Standard Deviation of Returns
…That Brilliantly + Simply Illustrates Portfolio Risk-Adjusted Return Profiles.
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Even Then…The Sharpe Ratio Proves To Be An Even Tighter Metric With The Inclusion…
In The Denominator…Of The Square Root Of The Time Period To Achieve Returns [as originally articulated by William Sharpe in 1966]…
Absolute Return – Risk Free Return / Standard Deviation of Returns * Square Root [Time Period]
…But Excluded By Most Contemporary Calculations…
Primarily Because It Softens The Quotient’s Result…
By Increasing The Value Of The Denominator.
Thus…Most Present Day Indications Of Sharpe Ratio = Severely Misleading + Over-Stated.
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Interpretation Of The Sharpe Ratio = Elementary…
As A Higher Absolute Result Is Preferred.
Sharpe Ratios Of 1.25 Are Generally Considered Good….1.75 = Excellent…2.00 + Greater = Superb.
As A Basis For Comparison…The Annualized Average Sharpe Ratio For The S&P 500 [1934 – 2022] = .45
…Which Includes The Square Root Of The Time Period In The Denominator.
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Despite Its Attributes…One Of The Greatest Criticisms Of The Sharpe Ratio =
The Ratio Is Not Necessarily Correlated To Higher Absolute Returns…
And That Is True…
But It Is Also True That High Absolute Returns Do Not Always Come At The Expense Of A Depressed Sharpe Ratio.
So…While Concurrently High Absolute Returns + Sharpe Ratios Are Nearly Impossible To Consistently Achieve…
They Are Attainable Over Truncated Time Frames.
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Thus…These Dual Objectives…Of High Absolute Return + High Sharpe Ratio…
Ought Not To Be Abandoned Due To Their Infrequency…
Because The Legitimate + Persistent Pursuit Of These 2 Elevated Quantitative Goals…Also Yields Significantly Positive Qualitative Consequences.
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Consider The Following Investment/Trading Scenario…For The L/S Money Manager…
Long Position: Initiated At $50/Shr.
Long Position: Liquidated At $65/Shr.
So…A 30% Return = Great Investment/Trade.
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Now…Contemplate 2 Different Pathways To $65/Shr.
Scenario I:
Long Position: Initiated At $50/Shr.
Price Draw-Down To: $40/Shr.
Revert To $65/Shr.
Scenario II:
Long Position: Initiated At $50/Shr.
Price Draw-Down To: $47/Shr.
Revert To $65/Shr.
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The Ultimate Profit…In Both Scenarios…Is Identical.
However…The Sharpe Ratio Impacts Are Quite Different…
As Scenario II Towers Above Scenario I…
Because A Higher Sharpe Ratio = Lower Capital Draw-Down.
Even Better Sharpe…
If Scenario II Trotted A Shorter Time Path To $65/Shr. Than Scenario I.
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Contemplate Also…For Each Scenario…
The Psychological Impact On The Investor/Trader…
As Capital Draw-Down = Concern/Stress = Poor Decision Making.
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For Scenario II Investor/Trader…The Concern/Stress Level = Low…
Freeing Up Mind-Share To Focus On Capital Management + Portfolio Composition = Sharp/Sound Decisions = Increasing Confidence = A Virtuous Cycle.
For Scenario I Investor/Trader…The Concern/Stress Level = High…
Consuming/Diverting Mind-Share + Impulsive/Sloppy Decisions Can Follow = Decreasing Confidence = Negative Feedback Loop.
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Naturally…Only The Confident Investor/Trader Is Capable Of Producing…
The Exceedingly Rare…And Very “High Class” Problem Of…
High Absolute Returns + High Sharpe Ratios.
And Only The Confident + Humble Trader…
Accepts + Understands The Tangential Features Of This “High Class” Problem.
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Contact The Author: [email protected]