What is a key reason the Sharpe ratio might be overestimated?

The Sharpe ratio is a measure used to evaluate the risk-adjusted return of an investment. It is calculated by taking the excess return of the investment over the risk-free rate and dividing it by the investment's standard deviation. A key reason the Sharpe ratio might be overestimated is when the standard deviation of the investment's returns is underestimated.

When standard deviation is underestimated, the denominator in the Sharpe ratio calculation becomes lower than it should be. This leads to a higher Sharpe ratio because the same excess return is being divided by a smaller number. In essence, if the variability of returns is not accurately measured, it results in a false impression of better risk-adjusted performance. Therefore, if the risk (as measured by standard deviation) is miscalculated or not fully reflected in the Sharpe ratio, it can mislead investors regarding the true performance and risk profile of the investment.

In this context, the other options do not directly contribute to an overestimation of the Sharpe ratio in the way that an underestimation of standard deviation does. For instance, high levels of diversification generally lead to reduced overall portfolio risk, and while regular measurement intervals and increased performance transparency are beneficial practices, they do not inherently cause the Sharpe ratio