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.