The Motley Fool Discussion Boards
Investing/Strategies / Mechanical Investing
|Subject: The Best Measure for the Best Blend||Date: 11/16/2007 12:01 AM|
|Author: Zeelotes||Number: 203942 of 263228|
What is the absolute best measure for finding the best blend?
If it isn't already, this should be the key question in everyone's mind -- at least, everyone who employs a blend for their MI investing. I've done hours and hours of testing over the past year or so to answer this question, compiling tests that include hundreds of millions of data points. At the very core, each test is trying to determine which measure is the most predictive of future return.
How did you set up the tests?
Well, I've run hundreds and hundreds of tests, but for this post, I'll be sharing based on using ranks 1-10 of each screen with a backtest history from 1969 to present. From these backtests I find five screens to invest in at the beginning of each year from 1989 using a descending sort of each of the measures. The # of lookback years to consider is varied from 1 to 29 in steps of two for a total of 15 lookbacks for each measure. I then take the results from this test and find the Minimum, Maximum, Median and Average value for each measure. I would consider the median and maximum to be key, but I also pay attention to the degree of deviation from max to min. The measure you actually use will also be used with a fixed number of years lookback so the maximum value is probably the one you will end up with, but we want to consider all to determine how robust the measure is. A vast span between min and max reflects a measure that probably just landed on such a high value by luck.
In summary, the period tested is 1989 to 11/9/2007 and the # of screens held is five holding ranks 1-10 for a total hold of 50 stocks. The idea here is not to necessarily hold 50 stocks, but to use this as a basis for finding the best measure. I've actually tested the exact same thing as this using ranks 1-4 and the results are not that much different, although the values are all higher.
All of the tables that follow are sorted by the Median column with the best values at the top.
What is the best measure for finding the highest future CAGR? In other words, which measure is most predictive of future CAGR?
A measure that is not talked about on this board comes out on top -- Jensen. The next one down is Alpha, also not often discussed as far as using it to predict future CAGR. The one that comes out on the absolute bottom is Sharpe/GSD recently suggested by StevnFool.
When looking at these returns, keep in mind that using the Solver to optimize and select a blend at the end of each year produced these results:
A Sharpe Optimized Strategy
CAGR around 26
Sharpe around 1.20
This then is the benchmark that we are comparing to.
But our goal is risk-adjusted return, not raw return, so what is the best measure for finding the highest Sharpe Ratio?
Well, you'll be surprised to learn that what is at the absolute bottom of the list above, comes out at the absolute top of the list for risk-adjusted return -- StevnFool's Sharpe/GSD. BTW -- I just added this measure to my backtester after he suggested it yesterday. As a result I had to run a special test just for that indicator and add it to all my other tests.
Sharpe Minimum Maximum Median Average
What measure comes out on top for Ulcer Index?
Once again we find that Sharpe/GSD comes out on top. We also see that although Jensen is great at finding the best screens to invest in at certain times, it does so at the expensive of a much higher Ulcer Index. If your goal is to find screens with just amazing forward returns then Jensen may be for you, but be forewarned, it will not be a smooth ride to the top.
UI Minimum Maximum Median Average
Which measure chooses screens with a high win ratio?
In other words, which of the measures tends to choose screens that consistently produce a positive return each year? Note again which measure comes out on top! Indeed, this simple little idea that StevnFool has come up with has produced some amazing results.
Win Ratio Minimum Maximum Median Average
When it comes to the maximum daily drawdown, which of the measures is able to avoid drawdowns the best?
Of course, here we are not suggesting that max drawdown is predictive of anything, but rather, evaluating how well a measure does at avoiding drawdowns. Once again we find that the winner is Sharpe/GSD.
Drawdown Minimum Maximum Median Average
Which of the measures you used actually produced a backtest with the lowest GSD?
You guessed it -- Sharpe/GSD comes out on top once again! In fact, this new measure comes out on top for every evaluation except CAGR. I sure do like the looks of those GSD values for the Sharpe/GSD strategy. A GSD around 10 is pretty much unheard of.
GSD Minimum Maximum Median Average