Newbie, confused about the Sharpe ratio

Discussion in 'Strategy Building' started by bobot, Jul 12, 2019.

  1. bobot

    bobot

    Isn't it quite useless if the returns are not normal? It favors strategies that consistently profit but have a rare but catastrophic loss. It seems to be a very popular metric so I can only assume most strategies would have this bias. Why is the Sharpe ratio used, and are there any alternatives to it?
     
  2. ph1l

    ph1l

    DaveV likes this.
  3. Craig66

    Craig66

    Nothing is perfect, trading is about practicality, not mathematical perfection.
     
    d08 and GRULSTMRNN like this.
  4. Snuskpelle

    Snuskpelle

    Why would the non-normality of returns make the Sharpe ratio useless?

    If you have two strategies that both yield 20%/year and one has Sharpe 1.2 and the other 2.0 I know which one I would pick. That the return distributions are fat tailed doesn't change that the return is accomplished for less risk on average.
     
    GRULSTMRNN likes this.
  5. bobot

    bobot

    See that's the point, what if the 2.0 is just based on an improbable event not happening?
     
  6. bobot

    bobot

    But using standard deviations on a non normal scale is just stupid.
     
  7. Snuskpelle

    Snuskpelle

    You under-appreciate the meaning of lower average risk. Basically, being in a drawdown sucks since you either need to wait it out or exit with a loss. Higher sharpe ratio means fewer drawdowns.

    In addition, it tends to be the case that a higher Sharpe strategy will simply have a (potentially significantly) lower maximum drawdown than a lower Sharpe strategy. The largest drawdowns are typically caused by longer sequences of bad trades, not by a single bad return (but there can be exceptions depending on strategy, for instance a highly levered high beta strategy getting killed by a gap).

    As you observe, the worst case tail event probably most certainly didn't happen during your backtest and something truly horrible can always happen. This is not related to the Sharpe ratio though.

    It really boils down what you are using the Sharpe ratio for. If you are using it to say X percent of returns will be below Y in absolute magnitude or something similar, then you're in deep water. However, for comparing one strategy to another it is great, and is typically reliable for that provided sufficiently large number of samples.
     
  8. comagnum

    comagnum

    You nailed it- the Sharp ratio is not a good metric for traders. The Sharpe fails to distinguish between upside versus downside volatility and assumes the markets follow a normal distribution around a curve which is dead wrong.

    The Sortino Ratio, Gain-to-Pain, Calmar, Profit Factor, & closed NAV with worst draw down are more practical metrics for traders.

    The Sharpe ratio was created to measure mutual fund performance - a whole different animal.


    http://www.redrockcapital.com/Sortino__A__Sharper__Ratio_Red_Rock_Capital.pdf
    https://oxfordstrat.com/ideas/sharpe-ratio/
    https://unovest.co/2017/08/sharpe-ratio-problem/
     
    Last edited: Jul 13, 2019
    d08 and IAlwaysWin like this.
  9. IAlwaysWin

    IAlwaysWin

    I tried explaining this to certain members on this forum but got bad attitudes in return.
     
    comagnum likes this.
  10. d08

    d08

    While you're correct, Sharpe ratio is still a pretty good measure of risk/return. I doubt you'd want to trade something that had one big equity spike and did nothing since. I believe this would have a high Sortino.
     
    #10     Jul 13, 2019
    Craig66 likes this.