When sizing up potential investments of different asset classes, investors turn to the risk-adjusted metric, the Sharpe ratio, to help them separate the wheat from the chaff. Unlike other measures such as alpha and beta, which rely on external index benchmarks, the Sharpe ratio relies on the investment's own numbers. This makes for a versatile way to compare all kinds of investment vehicles to get a preliminary idea of their reward potential. Despite its ease of use, the Sharpe ratio also draws criticism for not being as incisive as it could be.
The popularity of the Sharpe ratio has much to do with the relative straightforwardness of the formula used to derive it. You do not need to have an extensive financial background in math or statistics to grasp what the Sharpe ratio is theoretically trying to accomplish: to identify whether the excess return received compensates for the risk involved to obtain it. To calculate the ratio, you take the average rate of return on a given investment over a certain time period, such as three years, minus the risk-free rate over the same period, using Treasury bills, for example; all of this divided by the standard deviation, or how far the returns deviate from their mean. Generally, the higher the Sharpe ratio, the better, but it must be in the context of other investments.
Comparison Across Investment Types
The benefit of the Sharpe ratio, especially as compared with other risk measures, is that it can be applied to assets of all types. You can compare apples with oranges using the Sharpe ratio, because you are not referring to an outside reference point as the standard for that particular investment, making it just as applicable to individual securities as it is for portfolios and pooled funds. What will not be as useful is simply deriving a Sharpe ratio for one asset on its own. A number in and of itself does not reveal much unless it is compared with other Sharpe ratios of investments for the same time period.
Based on Normal Distribution
One of the reasons people find that the Sharpe ratio does not capture the real world is that it relies on standard deviation, which is based on the normal distribution curve. Some investments may exhibit such a distribution but it cannot encompass certain strategies, as when a huge payoff is a long time coming, on the heels of virtually no returns. Skewed distributions with rare occurrences could therefore result in inflated Sharpe ratios that do not address the whole story about the volatility of the investment. Selling deep out-of-the-money options is one example. In these cases, a Sharpe calculation would be misleading.
Does Not Differentiate Between Volatilities
Another weakness of the Sharpe ratio involves the way it treats all volatility the same. To an investor looking for a potentially rewarding investment, sharp volatility to the upside is not necessarily a bad thing, yet the Sharpe ratio does not differentiate them, and thus the volatility would be penalized in the formula. The result might lead an investor to think that the investment is not as worthwhile. Because the ratio sees negative and positive volatility in the same light, some believe that the ratio is not as rigorous or as fine-tuned as it could be.