Although it is essential to consider fund returns in the context of fund risks, the Sharpe ratio is a bit of a blunt instrument to measure risk-adjusted returns. Past returns don't predict future returns. And although relative risks among funds have a good deal of consistency over time, standard deviation is only a rough proxy for a concept as elusive as risk. Further, weighting risk as equal to return in importance in the formula is completely arbitrary. Here is the reality of investing, as I see it: An extra percentage point of standard deviation is meaningless, but an extra percentage point of return is priceless. Large differences in risk are extremely important - there is a difference between a stock portfolio and a bond portfolio - but the expedient of weighing risk and return equally, in a simple formula, leaves much to be desired. In the final analysis, risk-adjusted returns, like beauty, may be in the eye of the beholder.

YAHOO! FINANCE TIP Yahoo! Finance reports a mutual fund's Sharpe ratio on its risk page. For an example, see VFINX's risk page.

Despite these weaknesses, the Sharpe ratio is the principal instrument used by investment analysts to measure risk-adjusted returns. It presents a more complete picture of fund performance than raw return, and can help investors to evaluate the relative success of competing funds following the same broad investment strategies. Perhaps like all statistics, it can be remarkably useful, but only if its limitations are recognized.