07. Evaluating Performance on Unseen Data Demo

Part 1 - Sharpe and Sortino

Evaluating Investment Strategy Performance

Understanding how well an investment strategy performs on unseen data is critical for real-world success. This involves a step-by-step process including:

• Portfolio Returns Calculation: Application of risk parity weights to asset returns yields weighted returns, reflecting each asset's portfolio contribution.

• Performance Metrics: Key metrics help evaluate effectiveness and risk, including:

  • Annualized Return: Mean of portfolio returns, multiplied by 12. Result: 2.93%.
  • Annualized Volatility: Standard deviation of returns, multiplied by the square root of 12. Result: 3.3%.

• Sharpe Ratio: Measures return relative to volatility, assuming zero risk-free rate. Sharpe Ratio: 0.9.

• Sortino Ratio: Focuses on downside risk, calculated by dividing annualized return by downside volatility. Sortino Ratio: 1.4.

These metrics guide understanding of investment strategy performance by highlighting both risk and return aspects. Future topics include maximum drawdown and the Calmar ratio.

Part 2 - Calmar and Visualization

Understanding the Calmar Ratio for Portfolio Evaluation

The Calmar ratio is a metric used to assess the risk-adjusted return of a portfolio by accounting for drawdowns. Here is a simplified overview:

1. Purpose: Focuses on evaluating the risk-adjusted return concerning the maximum drawdown rather than overall risk.

2. Calculations Involved:

   • Cumulative Returns: Start with 1 + portfolio returns and compute the cumulative product.
   • Drawdowns: Calculate the difference between the cumulative max of returns and cumulative returns, divided by cumulative max.
   • Maximum Drawdown: Identify the largest drawdown over a period.

3. Calmar Ratio Formula: Determined as the annualized return divided by the maximum drawdown; a higher ratio indicates a better risk-adjusted performance.

4. Comparative Metrics:

   • Sharpe and Sortino Ratios: Measure overall and downside risk compensation.
   • Drawdown-related Metrics: Provide insights into potential loss severity.

By using these metrics, a deeper understanding of a portfolio's effectiveness under trading conditions enhances the strategy's reliability and soundness.