Definition and Example of the Sharpe Ratio
The Sharpe ratio, named after its creator William F. Sharpe, is a method for considering how to compare investment risks with their potential rewards. The Sharpe ratio is a measure that compares the returns of an investment to its risks. Calculating the Sharpe ratio involves subtracting the risk-free rate of return from the expected return rate and then dividing this result by the standard deviation, also known as “volatility.” The Sharpe ratio was first introduced in the mid-1960s by William F. Sharpe.
How Does the Sharpe Ratio Work?
The Sharpe ratio uses the risk-free rate of return, which is typically Treasury bonds since U.S. Treasury bonds are backed by the U.S. government. For example, if a specific Treasury bond has a yield of 4%, and this is used as the risk-free return rate in the calculation, then an investment needs to earn more than the risk-free return rate of 4% to compensate for the risks associated with the investment. The amount of price fluctuation of the investment is called “volatility.” The risk-free rate of return and volatility together can help determine whether an investment is worth the risk or not.
Sharpe Ratio Formula
To find the Sharpe ratio for an investment, subtract the risk-free rate of return (such as the yield of a Treasury bond) from the expected return rate of the investment. Then divide this number by the standard deviation of the annual return rate of the investment, which is a way to measure volatility.
Risk Analysis
When investing, you should always consider risk-adjusted returns when choosing where to invest your money. Failing to clearly consider the risks can cost you dearly in the long run. While beta and alpha coefficients are good ways to do this, you may prefer to use the Sharpe ratio instead, as it employs absolute measures rather than relative measures of risk. These metrics can be much more useful when selecting investments.
Limitations of the Sharpe Ratio
It is important to only compare very similar investments using the Sharpe ratio. Otherwise, it may not be as useful as it should be. The Sharpe ratio is useful when looking at mutual funds or exchange-traded funds (ETFs) that track the same underlying index. However, it does not work well when comparing stocks, especially when there are significant differences between the companies being compared.
Knowing that the Sharpe ratio shows its best results when comparing similar investments, you should keep in mind that those with a higher Sharpe ratio may be more volatile than those with a lower Sharpe ratio. A higher Sharpe ratio simply indicates that the risk profile of the investment is more optimized or fitting than others. However, there may also be significant risks involved.
It is also important to note that the Sharpe ratio is not presented on any type of scale, meaning it is only useful when comparing options.
Source: https://www.thebalancemoney.com/risk-adjusted-returns-with-sharpe-ratio-4120925
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