The Sharpe ratio is an investment measurement that is used to calculate the average return beyond the risk free rate of volatility per unit. In other words, itís a calculation that measures the actual return of an investment adjusted for the riskiness of the investment.
This measurement is particularly important when comparing two or more investment opportunities because it levels out the volatility in the market and flattens out the returns as if the risk was eliminated. Take a high-risk investment for example. This investment is much more volatile, increasing and decreasing in value much more, than a low-risk investment.
Assume that the high-risk investment had a higher return than the lower investment for a given year. Was this because the high-risk management or investment outperformed the low-risk investment or is this higher return simply based on the higher risk and volatility of the high-risk investment? You would never be able to know with out this ratio.
The Nobel laureate, William F. Sharpe, created the Sharp Ratio as a way to cancel out the risk component of investing in an effort to compare two different investment returns. Since his developed this formula, it has become the industry standard calculation. Letís see how to calculate the Sharpe Ratio.
The Sharpe Ratio formula is calculated by dividing the difference of the best available risk free rate of return and the average rate of return by the standard deviation of the portfolioís return. I know this sounds complicated, so letís take a look at it and break it down.
Here are the individual components:
- x = the investment
- rx = the average rate of return
- Rf = the best available rate of return of a risk-free security
- StdDev = the standard deviation of the return
Although the math might be a little complicated if you arenít familiar with finance equations, the concept is pretty simple. We are basically subtracting the risk free rate of return from the mean return to isolate the return based on the level of risk. We can then evaluate the investment performance based on the risk-free return.
Basically, the Sharpe ratio equation adjusts portfolios for risk and puts them all on a level risk playing field, so they can all be compared equally.
A higher Sharpe metric is always better than a lower one because a higher ratio indicates that the portfolio is making better investment decisions and not being swayed by the risk associated with it. Take a portfolio that only invests in Treasure bills for example. These are considered risk-free investments, so there is no volatility and no earnings in excess of the risk-free rate. Thus, the Sharp Ratio would be zero for this portfolio.
Other portfolios with higher rates of risk might have a metric of 1, 2, or 3. Any metric equal to or greater than 3 is considered a great Sharpe measurement and a good investment all else equal.
A metric of 1, 2, or 3 tells us how much additional return we are getting for holding an risky investment over a risk-free investment. In a sense, it shows us the level of compensation we are receiving for the additional level of risk we are taking with the investment.
Investors use this equation to see if they are comfortable with a particular investment. For example, they might feel that the return isnít high enough for a certain level of volatility. In this case, it would be a bad investment and they should look elsewhere for something with a higher Sharpe ratio.
Some people complain about the Sharpe calculator and say that it is too easy to misinterpret making the data misleading. Two alternatives to the Sharpe method are the Treynor ratio and the Sortino ratio.
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