Chapter 2: FAQs 87
What are the Most Useful Performance
Measures?
Short Answer
Performance measures are used to quantify the results
of a trading strategy. They are usually adjusted for risk.
The most popular is the Sharpe ratio.
Example
One stock has an average growth of 10% per annum,
another is 30% per annum. You’d rather invest in the
second, right? What if I said that the first had a volatility
of only 5%, whereas the second was 20%, does that
make a difference?
Long Answer
Performance measures are used to determine how suc-
cessful an investment strategy has been. When a hedge
fund or trader is asked about past performance the
first question is usually ‘‘What was your return?’’ Later
maybe ‘‘What was your worst month?’’ These are both
very simple measures of performance. The more sen-
sible measures make allowance for the risk that has
been taken, since a high return with low risk is much
better than a high return with a lot of risk.
Sharpe Ratio The Sharpe ratio is probably the most
important non-trivial risk-adjusted performance measure.
It is calculated as
Sharpe ratio=
μ−r
σ
whereμis the return on the strategy over some spec-
ified period,ris the risk-free rate over that period and
σis the standard deviation of returns. The Sharpe ratio
will be quoted in annualized terms. A high Sharpe ratio
is intended to be a sign of a good strategy.
