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.
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.
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.