For those of you new to the markets … are you wondering if the company mis-spelled the name of the website?
Shouldn’t it be “Sharp Trade”?
Sharpe Ratio is a metric. It’s a measurement. What does it measure? Well, let’s talk about that. Well, again … for you folks who are new, Sharpe Ratio measures an investors returns, to try to determine how skilled an investor is over time, given the risk he takes on, his performance given the volatility of his returns.
Ok. What does that all mean? Dan’s trying to explain a concept to newcomers and only four paragraphs in and he’s slipped back into “investor speak”. What does that definition mean?
Well, before we explain that, keep in mind there are several (and I do mean several) metrics to measure the performance of an investor / trader’s returns. This shouldn’t surprise us. View it somewhat like … say … baseball. In Baseball, you have the performance stats of a baseball player right? You’ll have his 2014 RBI, and his Career RBI. You’ll have his 2014 batting average, and his lifetime batting average. And many others stats. These statistics measure his performance.
So view investing performance metrics in sort of the same way. Only, we’re not measuring aspects of baseball performance, but an investors performance. And Sharpe Ratio is one such performance metric.
Related to this point, and important to keep in mind is that it doesn’t matter if it’s baseball, basketball or investing, one solitary statistic is not going to give you the whole story. If you heard that a baseball player’s RBI was 109, you might ask … “How long is that? Is that for one entire season? Part of the season? The lifetime of his career? Is he a rookie? And if he has a great RBI statistic, so what? What does his batting average look like? Runs vs. Home runs?” So obviously, you need a few different measurements, to get the feel of the performance of the baseball player, and even the period of time that this statistic covers.
The same is true of investing. So we say the above, to emphasize that a good Sharpe Ratio is by no means the “end all” performance metric, nor will it tell you ‘everything’ about an investors performance. But it is a good measurement.
But what does it do?
Ok, I could get into a lot of math here.
But I won’t. Not yet anyways. It has been said that mathematics is about describing what already exists. What is already there, and mathematics is only a language to describe problems and issues we study in reality. So let’s dispense with the mathematics of arriving at a Sharpe Ratio (and there are a few ways to do it), and for the purpose of this article let’s describe what the Sharpe Ratio actually measures with the English language. For now. We can describe how to calculate the Sharpe Ratio in another entry.
Let’s go back to our baseball player.
He’s in the major leagues, so you know that this guy should at least have a batting average for the season to this point, of .286. At the very least. But he’s batting .281. I mean, .286 would be poor. But .281 is just dismal.
What’s this players problem? He stinks when he steps up to the plate!
And then you notice, that every time he swings at that ball? It’s like he’s a mad-man, trying to crush the ball into the stratosphere, on the worst pitches imaginable. It doesn’t matter what is tossed his way! He stretches and reaches for that ball, as if he simply had to put it into orbit. No matter what pitch this player gets, he swings for the fences as if he is back in elementary school. And mind you, sometimes, this guy does connect with the ball, and it just goes soaring out of the park. But it becomes very obvious by watching him that although he is in the Major Leagues, and although he can really crush the ball when he connects, the reason for his low batting average is that he just can’t stop himself from ‘swinging for the fences’.
Believe it or not, we just described and investor with a bad Sharpe Ratio.
Sharpe Ratio is a metric, to tell you if that is the sort of investor / trader you have on your hands. It looks at a time frame under study (like a baseball ‘season’) for that investors returns, and tells you if this investor is just ‘swinging for the fences‘ each time he comes up to a trade, or if he is truly disciplined and really measures the pitch. The pitch that belongs to him.
How does a Sharpe Ratio measure this?
Well, if you are an experienced investor? Excuse me, because I’m about to greatly simplify the math and some of the discussions of calculation of Sharpe, to explain the concept.
The first question to consider, is how much of a return would you get on your money, if you just stuck it in the bank? That would be an investment of your money right? But it’s completely risk-free, so the return is very low. We could call this a risk-free rate. When you are free of risk (money just sitting in the bank) you get a very low return. Now, again, I’m simplifying this, as entire papers have been written on how to accurately measure the RFR or risk-free rate. But for the sake of a stay at home trader, let’s just call it, the money you stick in the bank.
The first thing Sharpe Ratio does, it looks at a few time frames. Let’s say … years. And it then says
Ok, how much did this investor / trader get a higher return, than that risk-free rate?
After all, you should at least be beating the interest you could receive just by sticking it in a savings account correct? Otherwise, you should just stick the money there.
So it takes an average of beating (hopefully) the risk free rate over some time, and compares the volatility of the investors returns, again over a few different time frames and takes that average. Why is this important? If his returns ZOOM higher (connecting with the ball and just crushing it out of the park), but then plummet his returns are said to be very volatile. He’s up 10% one week, and down 4% the next, and then down 7% the next week, and then up 13% the week after that?
This guy is just all over the place. He’s assuming risk by getting in the market, but his returns are so volatile, for the risk he’s taking on he is seriously heading towards a risk of ruin with his capital. His Sharpe Ratio will be low.
Because in the end, the volatile trader may be hitting 20% from time to time. But really, who of the two traders has longevity and looks like they could make steady gains year after year?
In essence, this is what Sharpe Ratio looks for, and why