# Sharpe Ratio: What It Means for Investment

## What is Sharpe Ratio?

The Sharpe Ratio is a measure used by investors to understand the return of an investment compared to its risk. Named after William F. Sharpe, a Nobel laureate and professor of finance, this ratio is a way to quantify the reward an investor can expect for the extra volatility they endure for holding a riskier asset.

## Understanding the Sharpe Ratio

The Sharpe Ratio is calculated by subtracting the risk-free rate – such as that of a U.S. Treasury Bond – from the expected returns of the investment, and then dividing the result by the standard deviation of the investment’s returns. The standard deviation is a measure of the investment’s volatility.

### Formula of Sharpe Ratio

The formula for calculating the Sharpe Ratio is as follows:

```Sharpe Ratio = (Expected return of investment - Risk-free rate) / Standard deviation of investment's return
```

## Interpreting the Sharpe Ratio

The Sharpe Ratio can be interpreted as the additional amount of return that an investor can expect to receive for each unit of increase in risk. A higher Sharpe Ratio indicates that the investment has historically provided good returns for its level of risk, while a lower Sharpe Ratio can suggest the opposite.

### Example of Sharpe Ratio Interpretation

For instance, if an investment has a Sharpe Ratio of 1.0, it means that the expected return of the investment is equal to the risk-free rate for each unit of the investment’s risk. If the Sharpe Ratio is 2.0, the investment is expected to return twice the risk-free rate for each unit of risk.

## Uses of Sharpe Ratio

The Sharpe Ratio is widely used by investors for several reasons:

• It allows investors to compare the risk-adjusted performance of different investments or portfolios.
• It helps in the process of portfolio optimization, where investors seek to maximize return for a given level of risk.
• It can be used to track the performance of a portfolio over time and identify any changes in risk-adjusted return.

## Limitations of Sharpe Ratio

While the Sharpe Ratio is a useful tool, it has its limitations:

• It assumes that the returns of an investment are normally distributed, which may not always be the case.
• It uses standard deviation as a measure of risk, which does not differentiate between upside and downside volatility.
• It may not be suitable for investments that do not have a linear relationship between risk and return, such as options and futures.

Despite these limitations, the Sharpe Ratio remains a popular and widely used measure of risk-adjusted return in the world of finance and investing.