The Deflated Sharpe Ratio: Correcting for Selection Bias, Backtest Overfitting and Non-Normality

22 Pages Posted: 1 Jul 2014 Last revised: 5 Jul 2015

See all articles by David H. Bailey

David H. Bailey

Lawrence Berkeley National Laboratory; University of California, Davis

Marcos Lopez de Prado

AQR Capital Management, LLC; Cornell University - Operations Research & Industrial Engineering; RCC - Harvard University

Date Written: July 31, 2014

Abstract

With the advent in recent years of large financial data sets, machine learning and high-performance computing, analysts can backtest millions (if not billions) of alternative investment strategies. Backtest optimizers search for combinations of parameters that maximize the simulated historical performance of a strategy, leading to backtest overfitting.

The problem of performance inflation extends beyond backtesting. More generally, researchers and investors tend to report only positive outcomes, a phenomenon known as selection bias. Not controlling for the number of trials involved in a particular discovery leads to over-optimistic performance expectations.

The Deflated Sharpe Ratio (DSR) corrects for two leading sources of performance inflation: Selection bias under multiple testing and non-Normally distributed returns. In doing so, DSR helps separate legitimate empirical findings from statistical flukes.

Keywords: Sharpe ratio, Non-Normality, Probabilistic Sharpe ratio, Backtest overfitting, Minimum Track Record Length, Minimum Backtest Length

JEL Classification: G0, G1, G2, G15, G24, E44

Suggested Citation

Bailey, David H. and López de Prado, Marcos, The Deflated Sharpe Ratio: Correcting for Selection Bias, Backtest Overfitting and Non-Normality (July 31, 2014). Journal of Portfolio Management, 40 (5), pp. 94-107. 2014 (40th Anniversary Special Issue).. Available at SSRN: https://ssrn.com/abstract=2460551 or http://dx.doi.org/10.2139/ssrn.2460551

David H. Bailey

Lawrence Berkeley National Laboratory ( email )

1 Cyclotron Road
Berkeley, CA 94720
United States

HOME PAGE: http://www.davidhbailey.com

University of California, Davis ( email )

One Shields Avenue
Davis, CA 95616
United States

HOME PAGE: http://www.davidhbailey.com

Marcos López de Prado (Contact Author)

AQR Capital Management, LLC ( email )

One Greenwich Plaza
Greenwich, CT 06830
United States

HOME PAGE: http://www.aqr.com

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States

HOME PAGE: http://www.orie.cornell.edu

RCC - Harvard University ( email )

1875 Cambridge Street
Cambridge, MA 02138
United States

HOME PAGE: http://www.rcc.harvard.edu

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