Effective return, risk aversion and drawdowns

We derive two risk-adjusted performance measures for investors with risk av erse preferences. Maximizing these measures is equivalent to maximizing the expected utility of an investor. The first measure, X-eff, is derived assu ming a constant risk aversion while the second measure, R-eff, is based on a stronger risk aversion to clustering of losses than of gains. The cluster ing of returns is captured through a multi-horizon framework. The empirical properties of X-eff, R-eff are studied within the context of real-time tra ding models for foreign exchange rates and their properties are compared to those of more traditional measures like the annualized return, the Sharpe Ratio and the maximum drawdown. Our measures are shown to be more robust ag ainst clustering of losses and have the ability to fully characterize the d ynamic behaviour of investment strategies. (C) 2001 Elsevier Science B.V. A ll rights reserved.