What's the limitation of Sharpe ratio?

Expert Solution

As per the definition, Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.

The term volatility is the standard deviation captured using the historical returns.

Disadvantages:
#1. It is based on historical data. The volatility is calculated using historical data, and volatility may not be the same in the future.
#2. It may not tell anything about the distributions of returns.The standard devations may not be able to capture the higher moments, i.e. skewness and kurtosis. Hence, sharpe ratio may not be reliable for a return distribution that is left skewed and leptokurtic (that is, stocks that post high mean return almost the time, but there may be a slight possibility of large losses).

#3 Sharpe ratio does not take into consideration the transaction costs involved.

Calculations like the Sharpe Ratio can be a tremendous advantage for a trader that knows how to use them

jeff jeffy answered 2 years ago

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