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Author: elann Big gold star, 5000 posts Top Favorite Fools Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 253284  
Subject: Re: Optimizing Blends with Sharpe/(GSD^x) Date: 11/17/2007 7:13 PM
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I always thought that the ultimate goal was to increase CAGR, not Sharpe. I thought people shot for high Sharpe because they thought that was how to get high CAGR. "Can't predict CAGR, but maybe we can predict Sharpe, so maybe we should aim for that."

I agree it would be silly to aim for high arithmetic mean return. But isn't a high geometric mean the absolute ultimate final goal to measure by? The way you know you won?

If we're aiming for high CAGR, the study looks a bit different.

And if you're not aiming for high CAGR, why aren't you? If your answer is "pain" or "short time horizon," well, you're already investing in a manner than can cause great pain. I want a better answer.

At this point, what do you think you can predict, and how confident are you? CAGR? Sharpe? GSD? Anything?


Retrospectively we all want high CAGR and nothing else matters. Prospectively we have to understand that we're only dealing with probabilities. We can't dial in a desired future CAGR and get it. So the name of the game is to maximize your expected return, not some illusion about absolute return. And since, for most people, the pain of potential underperformance is greater than the gain of potential outperformance, a goal that involves reduced risk is perfectly rational.

Think of it this way - even if a backtest was a perfect prediction of future behavior, it could only give us a mean expectation and some wide distribution around that mean. Through all possible future paths of a screen's return, there are many that would be undesireable, and you want to do something to avoid them if you can, even if you have to forego some of the potential CAGR.

Elan
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