when benchmarked against the returns of an industry sector or investing strategy the sharpe ratio provides a measure of risk adjusted performance not attributable to such affiliations 
the ratio is useful in determining to what degree excess historical returns were accompanied by excess volatility while excess returns are measured in comparison with an investing benchmark the standard deviation formula gauges volatility based on the variance of returns from their mean the ratio s utility relies on the assumption that the historical record of relative risk adjusted returns has at least some predictive value 1generally the higher the sharpe ratio the more attractive the risk adjusted return the sharpe ratio can be used to evaluate a portfolio s risk adjusted performance alternatively an investor could use a fund s return objective to estimate its projected sharpe ratio ex ante the sharpe ratio can help explain whether a portfolio s excess returns are attributable to smart investment decisions or simply luck and risk for example low quality highly speculative stocks can outperform blue chip shares for considerable periods of time as during the dot com bubble or more recently the meme stocks frenzy if a youtuber happens to beat warren buffett in the market for a while as a result the sharpe ratio will provide a quick reality check by adjusting each manager s performance for their portfolio s volatility the greater a portfolio s sharpe ratio the better its risk adjusted performance a negative sharpe ratio means the risk free or benchmark rate is greater than the portfolio s historical or projected return or else the portfolio s return is expected to be negative alison czinkota investopediasharpe ratio pitfallsthe sharpe ratio can be manipulated by portfolio managers seeking to boost their apparent risk adjusted returns history this can be done by lengthening the return measurement intervals which results in a lower estimate of volatility for example the standard deviation volatility of annual returns is generally lower than that of monthly returns which are in turn less volatile than daily returns financial analysts typically consider the volatility of monthly returns when using the sharpe ratio calculating the sharpe ratio for the most favorable stretch of performance rather than an objectively chosen look back period is another way to cherry pick the data that will distort the risk adjusted returns the sharpe ratio also has some inherent limitations the standard deviation calculation in the ratio s denominator which serves as its proxy for portfolio risk calculates volatility based on a normal distribution and is most useful in evaluating symmetrical probability distribution curves in contrast financial markets subject to herding behavior can go to extremes much more often than a normal distribution would suggest is possible as a result the standard deviation used to calculate the sharpe ratio may understate tail risk market returns are also subject to serial correlation the simplest example is that returns in adjacent time intervals may be correlated because they were influenced by the same market trend but mean reversion also depends on serial correlation just like market momentum the upshot is that serial correlation tends to lower volatility and as a result investment strategies dependent on serial correlation factors may exhibit misleadingly high sharpe ratios as a result one way to visualize these criticisms is to consider the investment strategy of picking up nickels in front of a steamroller that moves slowly and predictably nearly all the time except for the few rare occasions when it suddenly and fatally accelerates because such unfortunate events are extremely uncommon those picking up nickels would most of the time deliver positive returns with minimal volatility earning high sharpe ratios as a result and if a fund picking up the proverbial nickels in front of a steamroller got flattened on one of those extremely rare and unfortunate occasions its long term sharpe might still look good just one bad month after all unfortunately that would bring little comfort to the fund s investors sharpe alternatives the sortino and the treynorthe standard deviation in the sharpe ratio s formula assumes that price movements in either direction are equally risky in fact the risk of an abnormally low return is very different from the possibility of an abnormally high one for most investors and analysts a variation of the sharpe called the sortino ratio ignores the above average returns to focus solely on downside deviation as a better proxy for the risk of a fund of a portfolio the standard deviation in the denominator of a sortino ratio measures the variance of negative returns or those below a chosen benchmark relative to the average of such returns another variation of the sharpe is the treynor ratio which divides excess return over a risk free rate or benchmark by the beta of a security fund or portfolio as a measure of its systematic risk exposure beta measures the degree to which the volatility of a stock or fund correlates to that of the market as a whole the goal of the treynor ratio is to determine whether an investor is being compensated for extra risk above that posed by the market example of how to use sharpe ratiothe sharpe ratio is sometimes used in assessing how adding an investment might affect the risk adjusted returns of the portfolio for example an investor is considering adding a hedge fund allocation to a portfolio that has returned 18 over the last year the current risk free rate is 3 and the annualized standard deviation of the portfolio s monthly returns was 12 which gives it a one year sharpe ratio of 1 25 or 18 3 12 the investor believes that adding the hedge fund to the portfolio will lower the expected return to 15 for the coming year but also expects the portfolio s volatility to drop to 8 as a result the risk free rate is expected to remain the same over the coming year using the same formula with the estimated future numbers the investor finds the portfolio would have a projected sharpe ratio of 1 5 or 15 3 divided by 8 in this case while the hedge fund investment is expected to reduce the absolute return of the portfolio based on its projected lower volatility it would improve the portfolio s performance on a risk adjusted basis if the new investment lowered the sharpe ratio it would be assumed to be detrimental to risk adjusted returns based on forecasts this example assumes that the sharpe ratio based on the portfolio s historical performance can be fairly compared to that using the investor s return and volatility assumptions 