Sunday, December 18, 2022

Your Mental Sharpe Ratio


We are all familiar with the Sharpe Ratio, which calculates the amount of risk that we incur (drawdown) for a given amount of profit.  A positive, but low Sharpe means that we've made money over the relevant time period, but that we incurred quite a bit of drawdown along the way.  A high, positive Sharpe means that we have made money with a relatively smooth equity curve:  a steady trend rather than a choppy one.

Consider what I call the Mental Sharpe Ratio.  How much mental capital do we expend per unit of profit made?  If we make money, but find ourselves emotionally drained, frustrated, or anxious along the way, that would be a positive Sharpe Ratio but a negative Mental Sharpe.  If we lose money while learning a new strategy, but find the process intellectually stimulating, competitively challenging, and positively engaging in terms of teamwork, then we have a negative Sharpe Ratio, but a high and positive Mental Sharpe.

Too much of trading psychology is focused on reducing drains on mental capital.  That's helpful but will only make a negative Mental Sharpe less negative.  If we are approaching markets in ways that make use of our greatest strengths, interests, and values, then our trading should be *giving* us energy.  It's like a romantic relationship.  A good life partner inspires us and brings out the best in us.  A job is often draining, not a calling. 

If you're finding yourself working on your trading psychology day after day, it's like being in a marriage that you constantly have to work on.  Something isn't right.  The fit might not be there; what you're doing is most likely not your calling.  Review your most positive periods of Mental Sharpe:  that is very likely what you're meant to be doing in your trading.  Review your highest periods of Mental Sharpe outside of trading:  that is what you're meant to be doing with your life.

Further Reading:

Is Your Trading Purpose-Full?

Radical Renewal - A blog book on the spirituality of trading