The Sharpe ratio is a measure of performance or return on a portfolio. The performance of a portfolio has two components, risk and return. Along with the measurement of the return, it is essential to compare it with the risk to determine the overall efficiency of the portfolio. The Sharpe ratio compares the return of an investment with its risk. This article will detail the advantages and disadvantages of the Sharpe ratio.
Advantages of the Sharpe Ratio
The following are the advantages of the Sharpe ratio.
The Simplicity of the Concept
The Sharpe ratio is a very simple and straightforward method to measure the success or failure of a portfolio. The Sharpe ratio of a portfolio is its excess returns per unit of total portfolio risk. It is very simple to understand and contemplate the results of the Sharpe ratio. The Sharpe ratio is a great tool to determine the extra compensation that investors require to take on additional risk for their investments. The investors will only bear the additional risk if they receive additional returns, which can be calculated through a higher Sharpe ratio.
Comparison of Investments
One of the major advantages of using the Sharpe ratio is that it can be applied to all types of assets. This makes it easier to compare and evaluate the results among different types of investment. The Sharpe ratio is based on the total risk rather than systematic risk. This means that the Sharpe ratio uses standard deviation instead of stock beta to calculate the risk-adjusted returns. Not all portfolio managers believe in the principle of diversification to achieve a higher return. Investors with diversified as well as concentrated portfolios can use the Sharpe ratio to evaluate their portfolios’ performance. Therefore, they use the Sharpe ratio to compare different types of investment portfolios.
Disadvantages of the Sharpe Ratio
The following are the disadvantages of the Sharpe ratio.
Based on the Standard Deviation
The use of standard deviation for the calculation of the Sharpe ratio can be an advantage as well as a disadvantage of using this method. Analysts often believe that the Sharpe ratio does not capture real-world analysis. Standard deviation is based on the normal distribution of the curve. Some investments may be based on normal distribution but not all investments are based on normal distribution. The investments can be skewed or unevenly distributed because of which the Sharpe ratio becomes unreliable for analysis.
Systematic and Non-Systematic Risk
Systematic risk is the overall risk in the economy or markets that cannot be eliminated. Whereas, the non-systematic risk is related to a particular industry or company. Market researchers and analysts strongly believe that portfolio diversification can completely eliminate non-systematic risk. Hence, investors will not be able to earn any additional return for bearing non-systematic risk. The Sharpe ratio uses standard deviation for the calculation of risk-adjusted return instead of beta. This means that the calculation of risk-adjusted return is based on non-systematic risk. Therefore, market experts or analysts are not convinced about including non-systematic risk in the calculation of the risk-adjusted return through the Sharpe ratio.
No Difference between Volatilities
Another weakness of the Sharpe ratio is the way it treats all market volatility in the same way. Sharp upside volatility is not necessarily a bad thing for an investor searching for a potentially lucrative investment. But since the Sharpe ratio does not distinguish between them, the volatility would be punished in the formula. An investor might conclude that the investment was not as wise given the outcome. Some argue that the ratio is not as stringent or as well-tuned as it may be because it treats positive and negative volatility equally.