Investment for Intermediate and Long Horizons

The Sharpe ratio is based on a tradeoff between average return and return volatility, which is fully justifiable when returns are distributed normally. Even if the short-term (e.g. monthly) returns are approximately normal, their distributions become positively skewed as the investment horizon increases, and they eventually deviate substantially from normality. Despite this, we show that the monthly Sharpe ratio remains the correct criterion for ranking funds, even for long-run investors. This somewhat surprising result is based on the First-order Stochastic Dominance (FSD) rule.