Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

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nandonachi
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Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by nandonachi »

as per this: https://curvo.eu/backtest/en/compare-in ... rrency=usd, the sharpe ratio of S&P 500 is less than 1. And as per Investopedia sharpe ratio < 1 means suboptimal results - https://www.investopedia.com/ask/answer ... %2Doptimal.

How do i interpret this, given that stock market over longer periods of time is considered the best investment (for majority of us). If s&p500 doesnt have sharpe ratio > 1, then which instrument does?
exodusNH
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by exodusNH »

nandonachi wrote: Sun Jun 09, 2024 12:59 pm as per this: https://curvo.eu/backtest/en/compare-in ... rrency=usd, the sharpe ratio of S&P 500 is less than 1. And as per Investopedia sharpe ratio < 1 means suboptimal results - https://www.investopedia.com/ask/answer ... %2Doptimal.

How do i interpret this, given that stock market over longer periods of time is considered the best investment (for majority of us). If s&p500 doesnt have sharpe ratio > 1, then which instrument does?
From that article:
What Are the Limitations of the Sharpe Ratio?

The main problem with the Sharpe ratio is that it is accentuated by investments that don't have a normal distribution of returns. Asset prices have zero downside but have unlimited upside potential, making their returns right-skewed or log-normal. The Sharpe ratio assumes that asset returns are normally distributed. Many hedge funds use dynamic trading strategies and options that give way to skewness and kurtosis in their distribution of returns. A simple strategy of selling deep out-of-the-money options tends to collect small premiums and pay out nothing until the "big one" hits. Until a big loss, this strategy would erroneously show a very high and favorable Sharpe ratio.
It's not really the right measure because it assumes a returns distribution that doesn't actually exist.

It is useful as a relative measure between different funds. You can use it to compare the S&P 500 vs small cap vs actively managed funds, for example.
bombcar
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by bombcar »

The S&P 500 has never beat the S&P 500. And every index fund tracking it has fallen short.

Horrible investments. :D
gammalaser
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by gammalaser »

This thread has some good info
viewtopic.php?t=335282
bh1
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by bh1 »

The Sharpe ratio is nonsense. As supporting evidence, the result you refer to.
retireIn2020
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by retireIn2020 »

I spam Investopedia, garbage in garbage out.
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by nisiprius »

I don't think the Sharpe ratio is nonsense at all, and it can be a good BS-detector when e.g. an active fund is beating an index by taking more risk than the index. It can reveal that some fund that "beat" the market was taking more risk than the market, and on a risk-adjusted basis it didn't actually do better than an index fund. That's still just past performance and not predictive of the future, but at least it is an fair gauge of the past.

But let's separate two questions.

1) Is the Sharpe ratio actually good for anything?
  • Usually, any Sharpe ratio greater than 1.0 is considered acceptable to good by investors.
  • A ratio higher than 2.0 is rated as very good.
  • A ratio of 3.0 or higher is considered excellent.
  • A ratio under 1.0 is considered sub-optimal.
2) If so, are these reasonable and accepted criteria?

The answer to (1) is "arguably, maybe. Certainly 'arguable' in the sense of 'something people argue about.'" But it's no master key for choosing investments with superior future performance.

The answer to (2) is NO. Crazy. Garbage. Nonsense. Investopedia is often garbage, and this is one such time.

You aren't going to get a Sharpe ratio higher than 2 unless you're looking at a moment when some investment hits the jackpot. An investor who demands a Sharpe ratio higher than 2 is an investor who thinks they can get nothing but jackpots. And frankly I challenge anybody to find any "normal" stock investment that has sustained a Sharpe ratio of 3.0 or higher over any period of more than a couple of years, EVER.

Renaissance Technology's Medallion fund, possibly the most successful hedge fund of all time, has only had a long-term Sharpe ratio of 2.5.

The biggest problem with the Sharpe ratio, in my opinion, is just that like so many financial numbers it's wildly unstable, and is basically another measure of past performance. The good thing about it is that it is a measure that takes risk into account.

The following example is going to show two things.
  1. Even doubling your money in a year STILL doesn't necessarily give you a Sharpe ratio as high a 3.0. That's just nuts.
  2. An investment with a Sharpe ratio of 1.87 isn't necessarily a good investment. It can be 1.87 one year and -0.68 the next.
For example, consider the ARKK ETF:
Source

Image

it had a Sharpe ratio of 0.20, much lower than the S&P 500. It actually had roughly the same return, but with much larger fluctuations, and the Sharpe ratio pointed out that it was a much worse investment despite making roughly the same amount of money since it began.

But in February, 2021, when a poster made the infamous post Why the distain for managed funds like ARKK that destroy total market funds?, based on past history it had had a Sharpe ratio of 1.09.

Image

Even for the single year 2020, during which it more than doubled an investor's money, it only had a Sharpe ratio of 1.87.

Image

And it had 1.87 in 2020, and MINUS 0.68 the next!

Image
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Tamalak
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by Tamalak »

It is insanely tough to get a sharpe ratio over 1. It requires a high risk investment having a lucky run over a short time.
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Ben Mathew
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by Ben Mathew »

The investopedia article's benchmark for Sharpe ratios is completely unreasonable:
  • <1: suboptimal
  • >1: acceptable to good
  • > 2: very good
  • > 3 : excellent
A Sharpe ratio > 1 is implausibly high. It's much more likely to be the result of a lucky draw of high returns and/or low volatility that is unlikely to repeat. The example they gave shows how implausible this is:
Assume a mutual fund has an expected return over time of 25%. A risk-free rate of return is 2.70%. The standard deviation is 20%. Under these circumstances, the Sharpe ratio calculation is: (25 - 2.7)/ 20 = 1.11.
They had to make the assumption of 25% returns to get a Sharpe ratio slightly above 1.

The Sharpe ratio makes it a bit harder to cheat because it looks at both excess returns and volatility. But in any given period, there will always be some investments that get lucky and end up with a very high Sharpe ratios. To guard against this, it helps to look at longer periods, stick to broad asset classes, adjust for valuation changes, and ultimately use some judgment when interpreting historical returns and volatility. You might want to start with the position that the market portfolio has the the highest Sharpe ratio and treat claims of higher Sharpe ratios with some skepticism and a high bar for evidence.

A market portfolio with an equity premium of 3% and a standard deviation of 18% has a Sharpe ratio of 3%/18% = 0.17. That's reasonable. Much higher is suspect. Consider why everyone in the world is not clamoring to invest in the asset that supposedly has a Sharpe ratio > 1.
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by retired@50 »

bombcar wrote: Sun Jun 09, 2024 2:11 pm The S&P 500 has never beat the S&P 500. And every index fund tracking it has fallen short.

Horrible investments. :D
Right. And somehow, I was still able to retire.

Trailing the S&P 500 by 3 basis points has been a recipe for success, fingers crossed for the future.

Regards,
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Hacksawdave
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by Hacksawdave »

retired@50 wrote: Mon Jun 10, 2024 10:25 am
bombcar wrote: Sun Jun 09, 2024 2:11 pm The S&P 500 has never beat the S&P 500. And every index fund tracking it has fallen short.

Horrible investments. :D
Right. And somehow, I was still able to retire.

Trailing the S&P 500 by 3 basis points has been a recipe for success, fingers crossed for the future.

Regards,
Me too. Bur not to forget mentioning that I became a multi-millionaire by holding the index with winning companies such as Enron, General Motors, Lehman Brothers, Pacific Gas and Electric, TWA, Washington Mutual, WorldCom, plus some predating me as Pan-Am, Polaroid, Kodak, US Steel, Xerox…. :D
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Lawrence of Suburbia
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by Lawrence of Suburbia »

"Sub-optimal" comes across as a dirty word on this forum!
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Re: Sharpe ratio of S&P500 < 1. Does that mean its a bad investment?

Post by alluringreality »

A similar question was asked in the following thread. Personally I haven't ran across much to change my opinion. Generally I have some inclinations to agree with parts of the opinion from the second link.
viewtopic.php?p=6904440#p6904440
https://caia.org/blog/2022/02/19/sharpe ... ors-brains
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