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The Deflated Sharpe Ratio: Correcting for Selection Bias, Backtest Overfitting, and Non-Normality

Journal of portfolio management, 2014-01, Vol.40 (5), p.94-107 [Peer Reviewed Journal]

Copyright Euromoney Institutional Investor PLC 2014 ;ISSN: 0095-4918 ;EISSN: 2168-8656 ;DOI: 10.3905/jpm.2014.40.5.094

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  • Title:
    The Deflated Sharpe Ratio: Correcting for Selection Bias, Backtest Overfitting, and Non-Normality
  • Author: Bailey, David H. ; López de Prado, Marcos
  • Subjects: Bias ; Datasets ; Decision making ; High performance computing ; Investment advisors ; Investment policy ; Investments ; Studies ; Time series
  • Is Part Of: Journal of portfolio management, 2014-01, Vol.40 (5), p.94-107
  • Description: With the advent in recent years of large financial data sets, machine learning, and high-performance computing, analysts can back test millions (if not billions) of alternative investment strategies. Backtest optimizers search for combinations of parameters that maximize the simulated historical performance of a strategy, leading to back test overfitting. The problem of performance inflation extends beyond back testing. More generally, researchers and investment managers tend to report only positive outcomes, a phenomenon known as selection bias. Not controlling for the number of trials involved in a particular discovery leads to overly optimistic performance expectations. The deflated Sharpe ratio (DSR) corrects for two leading sources of performance inflation: Selection bias under multiple testing and non-normally distributed returns. In doing so, DSR helps separate legitimate empirical findings from statistical flukes.
  • Publisher: London: Pageant Media
  • Language: English
  • Identifier: ISSN: 0095-4918
    EISSN: 2168-8656
    DOI: 10.3905/jpm.2014.40.5.094
  • Source: ProQuest Central
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