The Sharpe Ratio Revisited: What It Really Tells Us

Abstract

One of the most ubiquitous measures of risk-adjusted performance is the Sharpe Ratio, yet many practitioners are not sure how to use it in evaluating investment opportunities or in constructing optimal portfolios. The difficulty with the Sharpe Ratio is that the result from an analysis is in units that are not readily absorbed by a user. After all, we know that a Sharpe of one is better than a Sharpe of 0.5, but are either good and what does a Sharpe Ratio of one really tell us? Prof. Modigliani acknowledged this challenge and adapted the Sharpe Ratio to come up with an alternative measure which expresses risk-adjusted returns in basis points. However, Prof. Sharpe recognized the limitations of his own measure (especially as it relates to multi-period investments) and offered some variations to adjust for these shortcomings, but these adjustments may not have been adequate. This paper will demonstrate that the Sharpe Ratio effectively only informs the user about the time needed to determine how skillful a manager may be in beating either the risk-free rate or a benchmark, and, even under these circumstances, we provide a more robust variation of the Sharpe measure for a multi-period evaluation.

Keywords: Sharpe Ratio, Risk-Adjusted Performance, Confidence in Skill, Time

JEL Classification: G11, G12