Question

Discuss three problems with the use of the Sharpe ratio to analyse the performance of a stock.

Answer 1

Three problems associated with the use of sharpe ratio to analyse the performance of a stock as follows-

A. It is based on the normal distribution- it is believed that Sharpe ratio does not capture the true standard deviation because it is based upon the normal distribution when calculation of the standard deviation. So it can be said that it does not capture the real world deviation when we are calculating the performance of the stock

B. No differentiation between volatility- problems associated with the use of sharpe ratio to analyse the performance of stock is that there will be no differentiation between the volatility and it is often believed that the volatility is penalized in the formula and it is not properly representative of the specific risk related to a particular investment

C. Sharpe ratio is relying upon the past data and past data will not always represent the true deviation and hence these historical past data will only be applicable when the macro Economic situation has been stable but when the macro Economic situation is highly fluctuating, then past performance cannot be used properly so sharpe ratio will not be a reflecting the proper return of stocks in such scenario.