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Sharpe Ratio



Definition

The Sharpe Ratio is a measure used in finance to understand the average return of an investment compared to its risk. It is calculated by subtracting the risk-free rate from the mean return of the investment, then dividing that result by the standard deviation of the investment’s returns. A higher Sharpe Ratio means a better risk-adjusted return on the investment.

Phonetic

The phonetics of the keyword “Sharpe Ratio” is: /ʃɑːrp ˈreɪʃioʊ/

Key Takeaways

  1. The Sharpe Ratio is a measure used primarily to understand the average return of an investment compared to its risk. The higher the Sharpe ratio, the better the risk-adjusted returns.
  2. It was developed by the Nobel laureate William F. Sharpe, primarily to help investors understand the return of an investment compared to its risk. The ratio highlights the additional amount of return that an investor could expect for taking additional risk.
  3. Sharpe Ratio cannot always be used to compare different types of investments due to its dependency on historical data. Various investments may have different risk and return characteristics and thus may not be comparable using this ratio alone.

Importance

The Sharpe Ratio is a crucial concept in finance and business because it measures an investment’s return relative to the risk taken to achieve that return. Created by Nobel laureate William F. Sharpe, it uses standard deviation to reflect the investment’s price volatility as a reflection of risk. A higher Sharpe Ratio indicates a more profitable investment relative to the risk involved. Therefore, investors use this ratio to compare the risk-adjusted performance of various investments or portfolios. It enables them to plan their investments more strategically by considering not only the potential returns but also the level of associated risk, leading to informed and direction-wise investment decisions.

Explanation

The Sharpe Ratio is a risk-adjusted performance measure developed by Nobel Laureate William Sharpe. It is used to help investors understand the return of an investment compared to its risk. The ratio is the average return earned in excess of the risk-free rate per unit of total risk or volatility. In simpler terms, it tells an investor how much extra return they are receiving for the additional volatility that they endure for holding a riskier asset.The primary purpose of the Sharpe ratio is to allow investors to analyze how much more return they are obtaining for the extra volatility they are experiencing due to holding an asset that is riskier than a less risky asset. In general, a higher Sharpe ratio means that your investment’s returns are better adjusted for risk than a portfolio with a lower Sharpe ratio. While it does not tell investors what the expected returns are, it does allow them to view the quality of those returns, given the relative amount of risk taken on by the investment. This provides insight critical to investment decision-making.

Examples

1. Mutual Fund Performance: Many investors use the Sharpe Ratio to compare the performance of mutual funds. For instance, Fund A generates an average return of 15% with a standard deviation of 10%, and Fund B produces an average return of 10% with a standard deviation of 7%. If the risk-free rate is 3%, Fund A has a Sharpe Ratio of 1.2 and Fund B has a 1.0. Despite the higher return, Fund A has a slightly higher Sharpe Ratio, implying it provides a better risk-adjusted return.2. Tech Startups Investment: Consider an investor contemplating putting money into two tech startups. Startup A has projected annual return of 25% with a standard deviation of 30% while Startup B has projected annual return of 18% with a standard deviation of 20%. Assuming the risk-free rate of return is 2%, Startup A has a Sharpe Ratio of 0.77 while Startup B has a Sharpe Ratio of 0.8. Even though Startup A has a higher expected return, Startup B is better when the risk is factored in.3. Pension Fund Assessment: Pension funds with large sums of money usually have diversified portfolios. One could be yielding an average return of 8% with a volatility of 5%, while another could have an average return of 6.5% with a volatility of 3%. If the risk-free rate is 1%, the first fund has a Sharpe Ratio of 1.4 and the second has a Sharpe Ratio of 1.83. Despite having a lower return, the latter is actually performing better on a risk-adjusted basis and could be preferred by pension holders who prioritize stability.

Frequently Asked Questions(FAQ)

What is the Sharpe Ratio?

The Sharpe Ratio is a measure that helps investors understand the return of investment compared to its risk. It was developed by Nobel laureate William F. Sharpe. The ratio describes how much excess return you receive for the extra volatility of holding a riskier asset.

How is Sharpe Ratio calculated?

The Sharpe Ratio is calculated by subtracting the risk-free rate from the expected portfolio return, then dividing by the standard deviation of the return. It’s usually calculated for a portfolio and uses the risk-free interest rate as benchmark.

What does a high Sharpe Ratio indicate?

A high Sharpe Ratio indicates that a portfolio’s returns are better-adjusted for risk, or that the portfolio is getting more return for each unit of risk taken on. A higher ratio can signal a superior overall risk-adjusted performance.

When is the Sharpe Ratio used?

Investors and portfolio managers use the Sharpe Ratio to gauge the performance of an investment or a group of investments on a risk-adjusted basis. It helps to evaluate whether higher returns are due to smart investment decisions or a result of excess risk.

Can a Sharpe Ratio be negative?

Yes, a Sharpe Ratio can be negative. This generally indicates that a risk-adjusted return is worse than the risk-free rate. In other words, an investor may have been better off holding a safer investment such as a government-issued bond.

What is a good Sharpe Ratio?

Generally speaking, a Sharpe Ratio of 1 or greater is considered good, 2 and over is very good, and 3 or over is considered excellent. However, these are general rules of thumb and the acceptability of a Sharpe Ratio can depend upon the context of the investment.

Can Sharpe Ratio be used to compare different types of investments?

Yes, the Sharpe Ratio can be used to compare the risk-adjusted performances of different types of investments or investment strategies. It allows for a comparison between the means by which excess returns were achieved, not just the returns themselves.

What are the limitations of Sharpe Ratio?

One limitation of the Sharpe Ratio is that it assumes that returns are normally distributed. It also assumes that all investors are risk averse, meaning that they require greater potential reward for taking on extra risk, which may not always be the case. Furthermore, it is not appropriate for portfolios that don’t have a bell-shaped distribution of returns.

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