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The Sharpe ratio is a measure of how well an investment compensates the investor for the risk assumed in making the investment.
The Sharpe Ratio or Sharpe Index or Sharpe measure or reward-to-variability ratio is a measure of the excess return (or risk premium) per unit of deviation in an investment asset or a trading strategy, typically referred to as risk (and is a deviation risk measure), named after William Forsyth Sharpe.
The Sharpe Ratio is a simple measure of the risk-adjusted return of an asset or portfolio. Using the Sharpe Ratio investors can compare investment strategies or managers, taking into account the amount of risk exposure each has in relation to their returns. The Sharpe Ratio was developed by William Forsyth Sharpe in 1966. (Sharpe was awarded the Nobel Prize in Economics in 1990 for his development of CAPM.) Due to its simplicity and ease of calculation, the Sharpe Ratio is a tool all investors can use to gauge their risk-adjusted-performance. The Sharpe Ratio also can help investors make decisions about their portfolio allocation.
The Sharpe Ratio is calculated by dividing the difference between the average return for the portfolio and the risk-free rate of return by the standard deviation of returns for the portfolio.
The formula for the Sharpe Ratio looks like this:
S(x) = (Rx – Rf) / StdDev(x)
Where x = portfolio, Rx = average returns of portfolio, Rf = risk-free rate of return, and StdDev(x) = the standard deviation of returns for x.
The Sharpe Ratio provides some insight into the efficiency of the portfolio by showing the amount of return generated per unit of risk assumed. The higher the Sharpe Ratio the better relationship of reward to risk in the portfolio. Because the Sharpe Ratio takes the volatility of a portfolio into account its use is helpful when comparing different investment strategies or managers. The Sharpe Ratio concludes that the strategy or manager exhibiting the highest return with the lowest amount of risk (as measured by standard deviation) would be the better choice.
The Sharpe ratio, which was developed by William Forsyth Sharpe, helps investors put risk into meaningful context. Two different investments may have very different risk profiles, but an investor may be quite comfortable taking on that risk if he or she is going to be adequately compensated for assuming it.
Investing in the stock market, for example, has nearly always been riskier than investing in bonds, but the stock market has historically provided much higher returns as well.
To provide that context, the Sharpe ratio compares the risk and return of a given investment with a baseline, low-risk investment such as Treasury bills. A high Sharpe ratio indicates that the investment is providing returns commensurate with its risk profile, while a low Sharpe ratio suggests that the risk is exceeding the expected reward.
To calculate the Sharpe ratio for a given investment, subtract the low-risk investment’s rate of return with the investment’s rate of return to define the “excess return”, then divide that by the investment’s standard deviation (which approximates risk).
For example, stocks have historically returned an average of 10%, while Treasury bills have historically returned 2%. Assuming a standard deviation of 15% (historically typical for an S&P index fund), then, stocks would have a Sharpe ratio of 0.53.
(10% – 2%) / 15% = 0.53
The Sharpe ratio is useful for comparing possible investments, but it has two significant challenges. First, it is necessarily backward-looking. If an investment’s behavior changes, the Sharpe ratio won’t predict it or account for it. Second, it assumes that risk is the same thing as volatility, which is true only in the short term.
Risk
Volatility
The Sharpe ratio is a measure of how well an investment compensates the investor for the risk assumed in making the investment.
The Sharpe ratio, which was developed by William Forsyth Sharpe, helps investors put risk into meaningful context. Two different investments may have very different risk profiles, but an investor may be quite comfortable taking on that risk if he or she is going to be adequately compensated for assuming it.
Investing in the stock market, for example, has nearly always been riskier than investing in bonds, but the stock market has historically provided much higher returns as well.
To provide that context, the Sharpe ratio compares the risk and return of a given investment with a baseline, low-risk investment such as Treasury bills. A high Sharpe ratio indicates that the investment is providing returns commensurate with its risk profile, while a low Sharpe ratio suggests that the risk is exceeding the expected reward.
To calculate the Sharpe ratio for a given investment, subtract the low-risk investment’s rate of return with the investment’s rate of return to define the “excess return”, then divide that by the investment’s standard deviation (which approximates risk).
For example, stocks have historically returned an average of 10%, while Treasury bills have historically returned 2%. Assuming a standard deviation of 15% (historically typical for an S&P index fund), then, stocks would have a Sharpe ratio of 0.53.
(10% – 2%) / 15% = 0.53
The Sharpe ratio is useful for comparing possible investments, but it has two significant challenges. First, it is necessarily backwards-looking. If an investment’s behaviour changes, the Sharpe ratio won’t predict it or account for it. Second, it assumes that risk is the same thing as volatility, which is true only in the short term.
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This glossary post was last updated: 28th November, 2021 | 0 Views.