Are You Obsessed with the Sharpe Ratio?

The Sharpe Ratio is essentially a measure of risk adjusted return which measures investment return per unit of risk. Presumably, the higher the Sharpe Ratio the better. Many quantitative investment firms require potential portfolio managers (PMs) to be able to demonstrate their ability to build investment portfolios with Sharpe Ratios exceeding a certain value. Again, the higher this numerical value the better. In addition, potential PMs are required to have a successful history of performance over the past two or more years. Also, PMs are expected to be idea generators who can continuously find new investment opportunities as recently discovered ideas become invalid after being found by others.

The Sharpe Ratio is not the “Holy Grail” of ratios. One major issue with this ratio is that it does not distinguish between volatility in the black vs volatility in the red. Without getting into the details, the Sharpe Ratio is just the average investment return over a period of time divided by the standard deviation of returns over the period. There are some other adjustments for the risk-free rate of return but that is not so relevant to our point. It is possible to have situations where investments with lower Sharpe Ratios are superior to those with higher Sharpe Ratios. This is particularly true when an investment strategy is more volatile than an alternative, but the volatility occurs more so when returns are in positive vs negative territory.

Imagine an investment strategy that never produces a negative return but returns fluctuate wildly between 0 and 100 percent versus a strategy that is relatively stable with returns ranging from -1 to 5 percent. Which strategy is better based on the highest Sharpe Ratio? It is possible that the first case could have the lowest Sharpe Ratio but have significantly higher returns while never producing a negative result. Blindly seeking high Sharpe Ratios is clearly naive at best. The best strategies are those that produce wonderful year over year returns with significantly lower risk than the overall market while avoiding significant losses versus any index. If your strategy’s Sharpe Ratio is higher than its benchmark with significantly higher returns, then that is all that truly matters as the numerical value of the Sharpe Ratio is irrelevant.

Also, Investment houses or hedge funds looking for idea generators who are constantly in search of new strategies are probably destined to underperform the market over time. In our view, the right strategy is one that consistently takes advantage of a changing basket of stocks with the ideal characteristics that present themselves over and over again monthly, quarterly, or annually. The key is to pick the correct rebalance cycle for your portfolio rather than changing your strategy or constantly looking for new strategies. The best PMs are idea generators but at the same time, good PMs realize when they have found the right strategy. When the winning strategy is found, the only thing left to do is maximize your earnings by sticking to your approach.

At Investoristics, winning is our focus and we feel that we have discovered a strategy that works for any investor, whether large or small. Any winning approach will essentially be similar with a focus on the fundamentals and common sense, anything else will not work consistently over time. If you are looking for a strategy that works, consider giving us a call to discuss if our portfolio is right for you. Our investment approach is sound and consistent with impressive results compared to any index. Tired of losing? Consider joining “The Collective.”