Comparing Alternative Investment Strategies Using Risk-Adjusted Performance Measures

Leggio, Karyl B.; Lien, Donald
January 2003
Journal of Financial Planning;Jan2003, Vol. 16 Issue 1, p82
Academic Journal
This article compares alternative investment strategies using risk-adjusted performance measures. Investment advisors are asked to recommend an investing strategy that increases returns while reducing the investor's exposure to risk. It was found that Sharpe ratio typically gives conflicting ranking results when compared with the upside potential ration (UPR). Investors are concerned with risk exposure. But the standard deviation of returns captures both positive and negative variation from the mean. Investors enjoy returns that vary from the mean when the variation is positive. The real sources of risk for investors are the variations from the mean that are negative. These behavioral findings call into question the validity of results found using the Sharpe ratio as the barometer of performance. The Sortino ratio begins to capture investor's concern with risk by replacing the standard deviation of returns with the downside risk as a measure of risk. The Sortino ratio, however, continues to use excess returns as the measure of returns. The UPR goes one step further by focusing the attention of the return measure on positive excess returns only. Traditional analysis uses the Sharpe ratio to evaluate the success of investing strategies. Dollar-cost averaging is not superior using the Sharpe ratio. More important, performance metrics that more accurately reflect investor risk and return such as the Sortino ratio and the UPR also fail to consistently support DCA as preferred investing strategy. DCA is typically a less volatile investing strategy; for a certain class of investors, it may be a preferred asset allocation technique. But research does not support the uniform recommendation of DCA as a preferred strategy. Investment advisors are urged to consider investor risk preferences before recommending an asset allocation strategy.


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