The Sharpe ratio, originally devised in the 1960s, essentially tells you if the potential return expected from an investment justifies the risks involved. It compares the probability of a large loss against the likelihood of a substantial profit. While the ratio is commonly used and can help make sense of available alternatives, it has important limitations.

## Definition and Calculation

The Sharpe ratio quantifies **how much excess return you get for each unit of risk** you are willing to take. Excess return equals profits higher than those offered by risk-free investment instruments. Since the federal government can print money to honor payment obligations, its bonds are risk-free.

By subtracting the return expected from holding an asset, such as a stock, from the risk-free rate, you arrive at its excess return. **Dividing excess return by the standard deviation of the asset** equals its Sharpe ratio. Standard deviation, a measure of investment risk, indicates how wildly the asset price fluctuates.

## Benefits of the Sharpe Ratio

An advantage of the Sharpe ratio is that it's **easy for investors to grasp and calculate**. Checking the rates of government bonds reveals the risk-free rate. You then merely plug return and standard deviation figures into the formula.

The Sharpe ratio also **standardizes the relationship between risk and return** and therefore can be used to compare different asset classes. Not only can you use it to compare different stocks, but you can also use the Sharpe ratio to weigh a corporate bond against an investment in gold, for example. The higher the Sharpe ratio, the better an investment option you have.

## Limitations of Past Data

While an accurate risk-free rate is easy to access, **finding the right expected return and standard deviation for an investment** is a real challenge. As always, you can use past data or try to predict the future.

In a highly stable environment, past data may work. If macroeconomic factors and the competitive conditions and product mix of a business haven't changed much in recent years, the return and standard deviation over that period may be a good predictor of expected numbers for the next year. However, in today's dynamic markets, the **future rarely replicates the past**.

## Limitations of Standard Deviation

Another challenge when using the Sharpe ratio is that the **risk may be hard to quantify by using just the standard deviation**. If potential gains and losses fall on a bell curve and have a normal distribution, standard deviation properly quantifies investment risk. If, however, the risk distribution is unusual, standard deviation can be misleading.

A business may be bidding for a government contract, which guarantees a large profit if earned. If it doesn't win the bid, however, a dozen options will be put on the table, resulting in significant uncertainty. The risk distribution of such a company does not resemble a bell curve, so the Sharpe ratio proves less useful.

### References

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