Is the Sharpe Ratio Useful in Asset Allocation?
Macquarie Applied Finance Centre Research Paper
48 Pages Posted: 9 May 2005
Date Written: May 2, 2005
Investors often consider Sharpe ratios when making asset allocation decisions and comparing portfolios. Given sampling error in estimated means and variances of returns, promoting Sharpe ratios as useful to help choose between asset allocations or portfolios may be misleading. Estimators of the Sharpe ratio have less helpful distributions than estimators of mean and variance. The error in the estimate of the Sharpe ratio can be simply too large to make useful conclusions. Investors are often overly swayed by historical performance in making investment decisions: why make matters worse by obscuring what information we have by combining past performance characteristics in an unhelpful ratio?
Keywords: Sharpe ratio, estimation error, GMM, asset allocation, portfolio choice
JEL Classification: C1, G1
Suggested Citation: Suggested Citation