In order to be sound in your financial goals, you need to have a great source of knowledge on every possible investment practice and technique. One such financial guide that you need to know while dealing with KPIs is Sharpe Ratio. The term Sharpe ratio denotes a Return or Risk measured amount provided by the annual average of the monthly returns, that deducts the yield of an investment without risk, provided it is divided by the standard deviation of fund returns.
This ratio is very important for investors, as they need to compare two or more investment methods – and eventually choose the one with the best outcome. This method levels out the volatility that’s currently present in the market and flattens the returns as well, by eliminating the risk factors of the investment.
For example, if an investor wants to compare a high-risk and low-risk investment, the eventual discovery will be that the investments with high-risk are more volatile and it can decrease the value while compared to the low-risk investment.
The Basics of Sharpe Ratio
The term Sharpe ratio was named after a Nobel laureate William F.Sharpe in 1966. He discovered a standard calculation for people to eliminate the risk component that comes with investment in order to compare between two or more different investment returns. The formula has now become standard in the industry.
Investors will make use of the Sharpe ratio in order to see if they are comfortable with such investments that they chose to compare. Based on the given level of volatility, they may conclude the level of return of an investment.
If the investor is not comfortable with that return, he or she will begin to search for other investments, preferably the ones that have a higher Sharpe ratio.
The Formula of Sharpe Ratio
In order to come up with the Sharpe ratio for a certain investment, we first have to subtract the best available rate of return of risk-free security from the average rate of return. Then, we’ll note this result for later, as there is the second part of this equation as well.
Now, we’ll take the previous result and divide it by the standard deviation of the return of the investment. The result will be the Sharpe ratio of that investment.
True, the equation might be a bit complicated, especially if you are not familiar with some of the terms above. Basically, in order to come up with the Sharpe ratio of an investment, we subtract the risk-free rate of return from the mean return, thus isolating the return based on the level of risk. Then, the investment has to be evaluated based on the risk-free return.
While making an investment, an investor will obviously look for a higher Sharpe ratio. A ratio that’s less than one is not good, a ratio between 1 and 1.99 is ok, a ratio between 2 and 2.99 is really good, and a ratio that’s higher than 3 is exceptional.
A higher ratio is important because it means the investor will make better investment decisions and he or she will not be moved by the risk that comes with a certain investment.
However, there are people who say that the data resulted from the Sharpe ratio formula can be easily misinterpreted and, therefore, misleading. Nevertheless, just try and calculate the ratio to know how safe your investments will be in the future. Try using an effective OKR tool to perform metrics spontaneously. There is various OKR software in the market, choose the best of it like Profit.co OKR Software and make your business goals attainable and quantifiable.