Having worked in finance I am a public fan of the Sharpe ratio. I have written about this here and here.
One thing I have often forgotten (driving some bad analyses) is: the Sharpe ratio isn’t appropriate for models of repeated events that already have linked mean and variance (such as Poisson or Binomial models) or situations where the variance is very small (with respect to the mean or expectation). These are common situations in a number of large scale online advertising problems (such as modeling the response rate to online advertisements or email campaigns).
Photo “eggs in a basket” copyright MicoAssist appropriate CC license
In this note we will quickly explain the problem. Continue reading One place not to use the Sharpe ratio
This is an elementary mathematical finance article. This means if you know some math (linear algebra, differential calculus) you can find a quick solution to a simple finance question. The topic was inspired by a recent article in The American Mathematical Monthly (Volume 117, Number 1 January 2010, pp. 3-26): “Find Good Bets in the Lottery, and Why You Shouldn’t Take Them” by Aaron Abrams and Skip Garibaldi which said optimal asset allocation is now an undergraduate exercise. That may well be, but there are a lot of people with very deep mathematical backgrounds that have yet to have seen this. We will fill in the details here. The style is terse, but the content should be about what you would expect from one day of lecture in a mathematical finance course.
Continue reading “Easy” Portfolio Allocation
The current state of the global financial markets has gotten more people than usual worrying about the technical aspects of finance. One method for reasoning about investment returns and risk is a tool called the Sharpe Ratio. It is well worth reviewing this measure and seeing how, if used properly, it doesn’t favor any of the mistakes that underly our current financial crisis. Continue reading A Quick Appreciation of the Sharpe Ratio