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Journal of Economics and Finance

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01-01-2013

A note on the evaluation of long-run investment decisions using the sharpe ratio

Authors: Ken Johnston, John Hatem, Elton Scott

Published in: Journal of Economics and Finance | Issue 1/2013

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Abstract

This paper reexamines the use of the Sharpe ratio to measure the performance of large and small company stocks along with corporate bonds over different holding periods. It builds on previous research which cites the effects of serial correlation and non-normality in the creation of estimation error in the calculation of the Sharpe ratio. It finds that higher order moments such as skewness and kurtosis are a further source of error that must be accounted for when making inferences about asset performance.

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Originally published by Ibbotson, the Stocks, Bonds, Bills, and Inflation® yearbooks are now available from Morningstar. See the yearbook for a detailed description of the portfolios.

Results of this paper do not change if sample data is restricted to the 1926–2000, the sample time period used by Best et al. (2007).

Higher order serial correlation results are similar.

The elimination of the last n-1 years is necessary to guarantee that the n-year holding-period return can be computed.

Lin and Chou (2003) examining equity returns also use this procedure to preserve serial correlation.

Only 30,000 trials are run in this simulation due to software constraints of Insight from AnalyCorp. Although it can run up to 1,000,000 trials (gives you the mean and standard deviation), it will only let you view a maximum of 30,000 trials. The individual trial data is required to calculate the higher order moments.

With a large sample size, a simulated n-period serial correlated return distribution will be nearly identical to the historical n-period overlapping distribution. Therefore it is appropriate to use the historical distribution in place of the simulated.

The Sharpe ratios in this study are calculated using the differential return. Each trial’s n-period compounded risk free rate is subtracted from the n-period compounded asset return. This array of differences is used to calculate the average difference and standard deviation of differences (See: Sharpe (1994)).

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Lin MC, Chou PC (2003) The pitfall of using the sharpe ratio. Finance Lett 1:84–89

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Morningstar (2007) Stocks, bonds, bills, and inflation. 2007 yearbook. Morningstar, Inc, Chicago

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Sharpe W (1994) The Sharpe ratio. J Portf Manag 49–58

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Title: A note on the evaluation of long-run investment decisions using the sharpe ratio
Authors: Ken Johnston
John Hatem
Elton Scott
Publication date: 01-01-2013
Publisher: Springer US
Published in: Journal of Economics and Finance / Issue 1/2013
Print ISSN: 1055-0925
Electronic ISSN: 1938-9744
DOI: https://doi.org/10.1007/s12197-011-9213-8

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