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Stock-to-Flow model creator PlanB recently revealed that Bitcoin is the only asset whose Sharpe ratio, which is used for determining risk-adjusted returns, is above 1. Thus, BTC significantly surpasses U.S. bonds, gold, and even FAANG stocks.
However, he faced some criticism from on-chain analysis Willy Woo who pointed to the fact that Bitcoin, due to its relatively short history, cannot be compared to assets that have already endured one or more bear markets.
They really should be calculated inside the same time period IMO, as Bitcoin has only ever existed inside a macro bull market, while many of those stocks weathered a financial crisis in 2008 and one or more bear markets which contributed to their Sharpe calculation.
— Willy Woo (@woonomic) January 25, 2020
Upping the ante
The Sharpe ratio was introduced by Nobel prize-winning economist William F. Sharpe to measure the returns of a portfolio while simultaneously taking into account its risk. A certain asset is compared to investments that are considered to be risk-free such as U.S. Treasury bills.
Any asset with a high Sharpe ratio is an attractive option for investors because it can potentially generate extremely high returns.
As the graph below shows, the Sharpe ratio is nearly zero for traditional assets such as U.S. bonds and gold since they have little to none volatility. The obvious downside of risk-free portfolios is that investors will not see any significant gains.
Not enough data
In his response to Woo, the Dutch analyst wrote that applying the same time period to Bitcoin and other assets could potentially lead to 'practical challenges.' For example, if to take into account only 2018-2019 data, this would not include the 40 percent stock market crash in 2008 as well as the dot com bubble in the late 90s that was even more severe than the crypto one in 2018.
Would indeed be better to use the same time period, but it would lead to practical issues. If we take 2009-2019 data, we would miss S&P -40% drop in 2008 and the dot,com -80% drop in 2000. If we take the full 50 years of bonds, gold and S&P, we miss FAANG and bitcoin.
— PlanB (@100trillionUSD) January 26, 2020
Does it work for Bitcoin?
Famed statistician Nassim Nicholas Taleb tweeted that the Sharpe ratio doesn't work for Bitcoin at all, which means that the above-mentioned comparisons didn't make any sense. Plan B agreed that it would be better to use fractal dimensions for his analysis.
True, Sharpe doesn't work for btc, esp. with classic bell curve risk measures like stdev/VaR. That's why I use max annual loss for risk. Indeed, given Stable/Power distr. of btc returns, fractal dimension would be better! I do think sizing bets with Kelly Criterion is useful here
— PlanB (@100trillionUSD) January 26, 2020
Taleb once reiterated that the variance of Bitcoin is infinite. In layman's terms, it means that Bitcoin cannot be overpriced.
BTC has infinite variance. Sharpe ratio is uninformative. pic.twitter.com/myxnuv9tk7
— Nassim Nicholas Taleb (@nntaleb) January 25, 2020
What's your take on PlanB's chart? Feel free to leave a comment!