Wednesday, March 9, 2016

Simplest Way to Improve Your Return to Risk Ratio

There is an industry standard to understand price volatility as a measure of risk. Most traders are too serious about it, they think it is a must to adopt the same understanding for their own. Actually, a risk is a pretty vague a notion, you can define it various ways. This is an advantage for a private investor, you can define what a risk exactly means for you.

You can understand a risk as a probability to underperform some risk-free benchmark on some time horizon. And now we have a parameter here - the time horizon.

If you hold a stock portfolio, the more the time horizon, the less the chances to underperform a risk-free benchmark because most factors creating local volatility have cyclical, mean-reverting nature. The longer you wait, the less are the losses they inflict to your portfolio. They may create a local volatility, but the overall action along the time horizon may be insignificant.

For example, you may observe periodical risk-off/risk-on trends, created only by massive emotional contagions. They create volatility spikes, extreme price actions, ruining your Sharp ratio. But they are cyclical and mean-reverting on scales rarely beyond a year.

So, the simplest way to improve your return to risk ratio is to redefine your risk to exclude local volatility as a measure, and to extend your time horizon so you could ignore short-time cyclical price actions.

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