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URL:  http://boards.fool.com/1-whether-cagr-optimizes-for-smooth-returns-it-26109832.aspx

Subject:  Re: Optimizing Blends with Sharpe/(GSD^x) Date:  11/17/2007  9:20 PM
Author:  JeffLandon Number:  204008 of 254159

1) Whether CAGR optimizes for smooth returns.

It does in this sense: When you write an optimizing backtester that looks for highest arithmetic mean, the results are much less even than when you write a backtester that optimizes for highest geomean. Bad years beat down CAGR unmercifully, at least compared to how arithmetic average is affected. (There is one interesting case where arithmetic is what you want--a young person who so far has little saved, but who is investing a fair amount monthly, can take advantage of volatility and is well served by optimizing for arithmetic average.)

2) Concerning the knowledge that GSD predicts GSD, but CAGR does not predict CAGR.

True. I never disputed that. But that's not my point at all. I agree that GSD is a better predictor of GSD than CAGR is of CAGR, but that doesn't mean something else doesn't predict CAGR.

Ever time you find a measuring stick, you should find out what it's good at measuring. Perhaps for some x, CAGR/(GSD^x) does turn out to be a good predictor of CAGR. By default, you're focusing on how it measures Sharpe.

Perhaps if you go back through all the screens pre- and post-discovery, you'll see that CAGR/(GSD*GSD) does predict CAGR. You'll never find what does because you've given up looking.

(And if you're convinced that you can't predict returns but only volatility, why are you even looking at Sharpe? You should only be interested in GSD if that's all you have a good handle on predicting.)

3) The idea that a measure which predicts CAGR would be good only for those who can stand the heat, and that pursuing such a path could lead to a 100% loss.

If a measure were to be found that predicts CAGR as well as GSD predicts GSD, would you still have this opinion? These high Sharpe screens can be very nearly as terrifying as the high cagr screens. And do you trust the prediction of the return portion of Sharpe? One is always served by some amount of distrust of these screens. That's where diversification and portfolio management come into play. Telling yourself you are safe because the backtested Sharpe is good can be very dangerous.
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