July 23, 2006

The Not So Sharpe Ratio

Investors are finding errors and discrepancies in the Sharpe ratio that hedge funds use to project their performance levels. The ratio is a measure of risk-adjusted return and calculates the difference between returns and a risk-free interest rate (generally the yield on US Treasury bills divided by the volatility or range of possible returns).

Nassim Nicholas Taleb, a hedge fund investor and a professor in the sciences of uncertainty at the University of Massachusetts Amherst, has propounded a set of arguments against the effectiveness of the Sharpe ratio:

  • Its volatility part is not a good measure of risk.
  • It assumes that economics and finance are solid sciences that permit the usage of statistical tools like the law of averages and the normal distribution in order to model returns.
  • It cannot be applied to socioeconomic variables like stock market returns where large or small losses and gains have a significant impact on the industry, unlike in a normal distribution where most results fall within a small range on either side of the mean, and a large anomaly or exception will not change the average unless it continues to dominate the sample even when the sample size increases.

Taleb’s conclusion is that the ratio is “like a horoscope – a bogus theory on which most people rely.”

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July 23, 2006 in Gossip & Scandal | Permalink




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