Want to Be Rich? Don't Use The Sharpe Ratio
A simple strategy can get us to $27M instead of $274k invested in bonds 27 years ago
In 1966, William F. Sharpe developed one of the most widely used metrics in Modern Portfolio Theory. Sharpe originally called it the “volatility-reward ratio” but later adopted Sharpe Ratio in honor of its creator.
This metric led him to win the Nobel Prize in economics a few years later. However, it is one of the metrics that provide the most negligible value and has been used the worst by economists and hedge fund managers. With it, they have deceived many investors into believing that their portfolio had less risk than it had, and this is not the case.
Taleb has always been critical of this metric, and I could not agree more.
“High Sharpe ratios are predictive of huge blowups. The more stable the return, the more likely the blowup. Volatile funds lose money; but not as much as nonvolatile ones.” — Nassim Taleb.
Knowing how to put volatility in your favor can make you a lot of money. People know this, but they don’t do it in the right way. That’s why in the long term, the portfolios of all these investors tend to be 0. These losses in purchasing power are mainly because these investors tend to look for portfolios with a high Sharpe Ratio. Still, by not taking volatility into account, they usually lose all their money along the way.
One of the comparisons where we can be sure that the Sharpe Ratio is useless is comparing very short-term bonds versus equities. Bonds historically have had a Sharpe Ratio of 0.8, while equities have had a 0.6.
In the example above, $100k invested in 1994 would have become $274k by investing all our capital in bonds, whereas if we had left all our money inequities, we would have $1.63M. Do you still believe in the Sharpe Ratio?
Another example, with a very high Sharpe Ratio, could be the Nasdaq leveraged x3, the famous TQQQQ. This ETF would have fallen to 0 during the 2000 and 2008 periods.
So, is it possible to have extraordinary performance and a high Sharpe ratio?
Yes, we do it, and the results are tremendously good.
It is crucial to track down what all those investors who fail in the attempt do:
Leverage: it requires a level of sophistication that many investors do not have. Also, as long as leverage is an option, some investors will choose to abuse it, usually by combining leverage with risk concentration or illiquid assets.
Illiquidity: enjoyable but also requires more investment skill than leverage. Private companies and private equity/private equity fall into the third category, as natural barriers to entry prevent capital from entering them.
We use the first one a lot. Leverage is very interesting to make a lot of money with low volatility (High Sharpe Ratio). You can achieve a high Sharpe Ratio by mixing asymmetric factors and risks. With assets that cancel each other out.
Here is a backtest (rebalanced by bands) that will make it more straightforward for you, composed of three portfolios:
Portfolio 1: leveraged, asymmetric risks.
Portfolio 2: S&P 500
Portfolio 3: Short-term bonds
A simple strategy can get us to $27M instead of $274k. A maximum drawdown is very similar to the S&P 500, with a return much better than double.
Our philosophy has always been to have an asymmetric portfolio, which can benefit even more from market asymmetries. It is a subscription that will honestly be (very) cheap for you in the long run.
There will always be the possibility of investing in short-term bonds and watching how inflation takes our money. You are the one who decides your destiny.