CFAI Vol 5, p88 Is point #5 saying that eliminating extreme returns, leads to LOWER standard deviations, which then leads to HIGHER Sharpe Ratio? The text says eliminating extreme returns, leads to HIGHER standard deviations, but why would it? Less extreme returns should lower standard deviation right? If not, why not?
Eliminated extreme returns effectively reduces standard deviation. Where did you read otherwise?
Eliminating extreme returns means extreme returns which will cause HIGHER standard deviations due to their high volatilities, thus lead to LOWER standard deviations and leads to HIGHER Sharpe Ratio.
Eliminating extreme returns means extreme returns which will cause HIGHER standard deviations due to their high volatilities “are excluded in calculation of standard deviation”, thus lead to LOWER standard deviations and leads to HIGHER Sharpe Ratio.
Leo_Land and AMC, I agree with both of you and myself. We are all on the same page. We are just not on the same page as CFAI Vol 5, PAGE 88. They conclude the opposite - see point #5 near the top of the page. Let me know what you think and whether you still believe that “eliminating extreme returns, leads to LOWER standard deviations, which then leads to HIGHER Sharpe Ratio” Thanks.
I think this must be an error. If it will cause HIGHER standard deviations (& Lower Sharpe Ratio), then Sharpe Ratio is gamed ? Usually gamed Sharpe Ratio means it is higher than TRUE Sharpe Ratio, right ? Am I wrong ?
AMC Wrote: ------------------------------------------------------- > Eliminating extreme returns means extreme returns > which will cause HIGHER standard deviations due to > their high volatilities “are excluded in > calculation of standard deviation”, thus lead to > LOWER standard deviations and leads to HIGHER > Sharpe Ratio. THIS IS CORRECT…CFA CURRICULUM STATES THIS…WHERE IS THE DISAGREEMENT?
The important thing to remember here (and undisputed fact) is that the Sharpe ratio can be gamed by eliminating extreme returns, i.e; a manager can swap highest and lowest return out of fund- By eliminating the extreme returns, both high and low, standard deviation is lower, resulting in a higher Sharpe. That’s what CFAI wants you to know for exam day, IMO.
Leo_land & smokin’hot, CFAI Vol 5, PAGE 88. point #5 : The statements are correct ?
No it’s not it’s an error: they mean it increases the Sharpe ratio. ERRATA Refer to question 23 in the same chapter, the correct explanation is provided.
Leo_land, Thanks, I will look at CFAI’s ERRata & question 23.