In my short post Is Volatility A Risk?, I urged that any definition of risk:
should be evaluated by its usefulness. Any single definition is incomplete and insufficient for making an investment decision.
Here’s a specific case.
This is a good overview the shortcomings of Sharpe ratio, most of which should be well-understood by anyone who has computed a standard deviation.
I’ll expand on some of the less obvious points:
Why? Because you are understating the vol which you can no longer assume scales at the square root of time. This is a complicated issue because auto-correlation, while easy to compute, is itself subject to variation.
A quick demo:
a) Bet $1 on a fair coin
b) Bet $.33 on heads on a coin that costs 9-1 if tails but has 90% of coming up heads (still a fair coin).
These bets have the same vol ($.33 creates risk or vol parity weighting) but the payoff shape is materially different.
Ok, I’m done suspending my disbelief that anyone uses a a single metric in isolation to decide anything of importance. The post is worthy reading for new investors who just discovered Sharpe before they run out and impale themselves on it. I hope my additions made it a touch more interesting for the initiated.
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