The Sharpe Ratio: A Valuable Tool with Limitations Investors Should Consider

William Sharpe

The Sharpe Ratio: A Valuable Tool with Limitations Investors Should Consider

The Sharpe ratio, a widely recognized financial metric, helps investors evaluate the risk-adjusted performance of an investment. Developed in 1966 by Nobel Laureate William Sharpe, this popular tool has limitations. In this article, we’ll explore the Sharpe ratio, its benefits, and the potential pitfalls investors should be aware of when using it.

Understanding the Sharpe Ratio

The Sharpe ratio measures the excess return per unit of risk, calculated by dividing the difference between the portfolio return and the risk-free rate by the standard deviation of the portfolio return. A higher Sharpe ratio indicates better risk-adjusted performance, with more significant returns relative to the level of risk taken.

Here’s the formula:

Sharpe Ratio = \(\frac{R_p\ – r_f}{\sigma_p}\)

\(R_p\) is the annualized rate of portfolio return,

\(r_f\) is the annualized risk-free rate,

\(\sigma_p\) is the annualized standard deviation.

The high Sharpe ratio is expected for better-performing funds. A higher Sharpe ratio indicates relatively excessive returns with a relatively low standard deviation.

The Sharpe ratio is used with realized returns instead of forward-looking, expected returns. A higher Sharpe ratio indicates relatively excessive returns with relatively low standard deviation.​

William Sharpe

Limitations of the Sharpe Ratio 

While the Sharpe ratio is a useful tool for investors, it’s crucial to understand its limitations to make informed decisions:

  1. Illiquid investments: The Sharpe ratio may overestimate the performance of illiquid investments, which can smooth data and underestimate risk. This results in an upward bias, which also affects instruments with default risk and catastrophe risk.
  2. Time frame sensitivity: According to Spurgin (2001), extending the time frame can increase the Sharpe ratio. The excess return in the numerator may remain unchanged, while the standard deviation in the denominator may decrease due to the square root of the time interval.
  3. Non-normal distribution of returns: If investment returns have fat tails or negative skewness, the standard deviation calculation may be flawed, leading to an inaccurate Sharpe ratio.
  4. Lack of correlation consideration: The Sharpe ratio focuses on individual investments and does not account for the correlation among assets or the entire portfolio.
  5. Historical data reliance: The Sharpe ratio is often based on realized returns, which rely on historical data. However, past performance may not be indicative of future results.
fat tailed distribution
Source: Wikipedia

Illiquid investments underestimate the risk and smooth data, which results in the upward biased Sharpe ratio. The ratio only focuses on the individual investment and does not calculate the correlation among other assets or the portfolio.​


In a Wall Street Journal interview, Dr. Sharpe himself admitted that he does not use his ratio to evaluate hedge funds and that it can be manipulated. He even mentioned that he initially called it the “Reward-to-Variability ratio.”
As investors, it’s essential to utilize various metrics and ratios and avoid relying solely on a single formula. While the Sharpe ratio can offer valuable insights into risk-adjusted performance, understanding its limitations is crucial for making well-informed investment decisions.

Disclosure: I do not have any of the securities mentioned above. This article expresses my own views, and I wrote the article by myself. I am not receiving compensation for it. I have no business relationship with any company whose security is mentioned in this article.


Mehmet E. Akgul

Covers investment, financial analysis and related financial market issues for BrightHedge. He has extensive experience in portfolio management, business consulting, risk management, and accounting areas.