Twisting the Sharpe Ratio
by Qian Zhu and Tom Starke
If you want to learn about things deeply, you need to break them. Sharpe Ratio is one of the top metrics used by traders and investors to evaluate their trading strategy/investment systems. It is often referred to as the ‘risk-adjusted performance measures’, which gives confidence to investors by comparing the portfolio to a risk-free benchmark.
The Sharpe ratio is calculated as follows,
However, as we will see in the following sections, it can be ambiguous and may lead to misleading interpretations-the consequence of which may seriously impact our trading capital. To demonstrate this, let us look at a simple Buy and Hold strategy for a portfolio consisting of the e-commerce giant Amazon as the single asset. The trading strategy consists of the following logic:
- start buying at Day 3;
- exit after holding for 60 days;
- wait for 2 days before trading again;
- repeat.