Just as we look at fuel economy when we plan on buying a new car, we are used to looking at the Sharpe – the risk-reward ratio – of our investments to see if we are allocating capital efficiently or if we take too much risk compared to the return. Although efficiency is definitely a desirable feature, achieving it takes much more effort than investing in the portfolio that had the best Sharpe ratio in the past. The reason for this is twofold: you cannot invest in the same market twice and Sharpe ratios often lie.

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Nevertheless, portfolio optimization is one of the most powerful tools we have to manage investments. Here, we are going to take a closer look at its mechanisms: how it works, why it is useful and which errors we must avoid to do it properly. As we are going to see, it is forward – rather than past – efficiency that we should aim to maximise. To achieve it, we must stop looking in the rearview mirror and position ourselves for stability and efficient market dynamics. In a sense, getting sharper than Sharpe.

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You Cannot Invest in the Same Market Twice

Several of the most important ideas of our modern world originated long ago. Especially when it comes to fields that share a centuries-old tradition, such as philosophy, mathematics or astrology, many groundbreaking ideas have been born out of a simple and sometimes naive observation of nature.