I run some numbers to try to figure some things out. I compared the Daily, weekly and monthtly volatility of SPY to TLT and IEF. Yahoo has data going back to 2002 for all of them.
So, the more you lenghten the time horizon, the less volatile the stock market is compared to the bond market. The same thing happened by only looking at the Standard Deviation of Negative Returns only as it can be seen bellow
Whats interesting is that the improvement stops with yearly data but only for the SD, SD of Negative Returns still improve
I dont have yearly data for the 30y for a big enough sample but looking at IEF and the 10y bond data from my US database only I'm getting this
SD Ratio of SPY/S&P500 to IEF/10y Bonds Daily/Weekly/Monthly/Yearly
SD 2.79 2.69 2.18 2.25 (it gets worse for the last one, the yearly data)
SD Negative Returns 3.47 3.36 3.01 2.53 (improvement continued with yearly data)
The stock market is consistently volatile, it gets less volatile as you lengthen the time horizon but that improvement seem to be limited to less negative years. The market will still be volatile to the upside. Its just that the more time you give, the less of a chance of a negative outcome for stocks
Of course, all of this is pretty obvious but it has important implications to the use of the Sharpe Ratio vs Sortino Ratio
The Sortino Ratio looks at SD of Negative Returns only, it goes to what people care about more, losses. The Sharpe Ratio looks at Standard Deviation in general. As a result an investment strategy that relies on it will be underweight equites compared to one that doesn't. This explains why on some of my tests, using the Sortino, the computer recommended a fair amount of stocks compared to the Sharpe, when the Sharpe was used as metric, the computer was more risk averse
The people at Bridgewater are very smart and they probably know all of this, so why are they relying on the Sharpe instead of Sortino? I think that has to do with the fact that they are a hedge fund/investment manager, this leads them to prefer the Sharpe instead of Sortino for a few reasons
-Clients tend to care about month to month, week to week volatility. Relying on the Sharpe will create a portfolio with less short-term volatility because it will have less equities in them and decrease that type of short-term volatility that can lead to clients complaints
One way to see this is to look at the daily SD of negative returns/SD. The 3.47 from above divided by 2.79, 1.24 is the result. For yearly data, 1.12 is the result. So as time passes, even though the SD remains high for stocks, more of that SD is coming from upside volatility, not downside volatility. Downside volatility is coming down and more positive years become likely
-The Sharpe is more well-known by clients and people in finance and they can understand it better. Most people never even heard about the Sortino
-Because the future is unknown, its possible that in the future things will be more volatile. An Extremistan type world requires a more conservative allocation. Since equities tend to be the most sensitive asset to this sort of issue, they would prefer a metric that punishes it (the Sharpe)
-Other reasons I havent thought about it
I'm not sure these reasons are good enough for me to switch to the Sharpe, especially given that I have no clients. I think it makes more sense and as a result, if one has the stomach to ignore day to day, month to month noise, using the Sortino and the computer recommeded portfolios is the way to go. That Extremeistan adjustment can be made by decreasing the equity allocation a little bit, but still, relying on the Sharpe leads to some big differences compared to the Sortino (35% vs 50% in stocks, plus the Sharpe wants you to load up in bonds like there is no tomorrow)
I plan to do more thinking/research on this topic
