What are the limitations of the Sharpe Ratio?

What are the limitations of the Sharpe Ratio?

The Sharpe Ratio is a popular measure of risk-adjusted return, but it has several limitations. For instance, it assumes that returns are normally distributed, which is often not the case in real markets. Additionally, it can be misleading during periods of high volatility.

Can you explain why the normal distribution assumption is a problem?

Sure! The normal distribution assumption implies that extreme events are rare, but in financial markets, we often see 'fat tails' where extreme returns occur more frequently than predicted. This can lead to an underestimation of risk.

What about the time period used for calculating the Sharpe Ratio?

Great question! The time period can significantly affect the Sharpe Ratio. A short time frame may not capture the full volatility of an investment, while a longer period may include outdated data, leading to skewed results.

Are there any alternatives to the Sharpe Ratio?

Yes, there are several alternatives, such as the Sortino Ratio, which only considers downside risk, and the Treynor Ratio, which uses beta to measure risk. Each has its own strengths and weaknesses.