Choosing a performance metric
We should account for risk and for transaction costs.
The “Sharpe ratio” is the standard metric for risk-adjusted return.
- Given a sequence of returns, the Sharpe ratio is the mean of each return minus the risk-free return, divided by the standard deviation of the returns.
- The risk free return is the interest earned by short-term U.S. Treasury bills (around 5% in the 1990s).
Transaction costs have at least four components: commissions, slippage, spread, and market impact.
- By trading mutual funds we avoid spread and market impact costs.
- Commissions are low: $30 roundtrip using a broker.
- Slippage will arise principally from the fact that we must commit to trades some time before the close of the New York markets, perhaps one hour before.
We model transaction costs as 0.1% roundtrip. We do not adjust for risk.