William F. Sharpe invented the risk-adjusted Sharpe ratio. It calculates volatility, which is the excess return per unit variation from the mean. Investors and financial advisors use the Sharpe ratio to measure investment success vs. risk. The balance is computed by subtracting the risk-free rate of return from the investment’s average return and dividing it by the investment’s standard deviation. The Sharpe ratio shows the investment’s risk-adjusted return per unit of risk. A percentage of 1 or greater is good, whereas a ratio below 1 indicates that the investment may be riskier than it should be. A portfolio’s risk-return trade-off can be determined using the Sharpe ratio. The Sharpe ratio should be utilized as a part of a more considerable investment study, not as the primary element.
Formula
The formula for the Sharpe ratio is as follows:
(Expected return of investment – Risk-free rate) / Standard deviation of investment returns.
The expected return on the investment is the average expected return over a certain period. The risk-free rate is the return that can be earned on a risk-free asset, such as a Treasury bond. The standard deviation of the investment returns measures the volatility of the returns. It is a statistical measure of the dispersion of data points around the mean (expected return).
Interpretation
If an investment has a more excellent Sharpe ratio, it shows that it yields superior returns compared to the amount of risk taken. For instance, if two investments both have the same expected return, the more excellent Sharpe ratio is considered the superior investment since it offers a more significant return for each point of risk taken on.
It is generally accepted that a Sharpe ratio of 1 or more is superior to a percentage of less than 1, which is undesirable. It is essential to remember that the investor’s investment objectives and level of comfort with risk determine how the Sharpe ratio should be interpreted. A low Sharpe ratio may be acceptable for an investor seeking high-risk, high-reward investments; however, a high Sharpe ratio may not be sufficient for a risk-averse investor.
Limitations
The Sharpe ratio is a statistic utilized rather frequently; nevertheless, it has a few drawbacks. First, it assumes that the standard deviation of returns can completely characterize the risk associated with the investment, which is something other than what is guaranteed to be the case. Second, it presupposes that the returns are regularly distributed, which is not necessarily the case and may not even be the case at all. Last, the Sharpe ratio considers only the mean return and the standard deviation of returns. It does not assume any other aspects of the returns distribution, such as the skewness or kurtosis of the distribution.
Conclusion
The Sharpe ratio is a valuable tool for evaluating the risk-adjusted return of an investment. Still, it should be used in conjunction with other measures of investment performance, such as the alpha and beta coefficients, and with a clear understanding of its limitations.
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