The Sharp Razor: Performance Evaluation with Non-Normal Returns
45 Pages Posted: 23 Sep 2012 Last revised: 28 Jul 2014
Date Written: September 23, 2012
Because the Sharpe ratio only takes into account the first two moments, it wrongly “translates” skewness and excess kurtosis into standard deviation.
As a result: It deflates the skill measured on “well-behaved” investments (positive skewness, negative excess kurtosis). It inflates the skill measure on “badly-behaved” investments (negative skewness, positive excess kurtosis).
Sharpe ratio estimates need to account for Higher Moments, even if you assume that investors only care about two moments (Markowitz framework).
Keywords: Portfolio selection, Normality, Serial Correlation, Probabilistic Sharpe Ratio, Minimum Track Record Lenght, Sharpe Ratio Efficient Frontier
JEL Classification: C02, G11, G14, D53
Suggested Citation: Suggested Citation