Timing versus Sizing Skill in the Investment Process

Abstract

This article analyses the effects of skill in timing and skill in sizing on the Information Ratio (IR). The author shows that risk-adjusted returns can be decomposed into the Hit Ratio, the Win/Loss Ratio, and Breadth. The Hit Ratio represents skill in market timing and measures the relative frequency of investment decisions that prove correct. The Win/Loss Ratio represents skill in position sizing and measures the relative magnitude of profits versus losses. The results show that it is possible to realise positive IRs even when most investment decisions prove incorrect. The author allows for fat tails and shows that the theoretical results hold against empirical results from other papers and against simulations, also when the underlying assumptions are violated. The framework can be used to decompose skill underlying an investment process into a timing and sizing dimension.

TOPIC: Performance measurement