This is an investment measurement and is used to calculate an investment’s average return beyond the risk-free rate of volatility per unit. Basically, the Sharpe ratio is used to determine the return of a certain investment, which is also adjusted for the investment’s riskiness.
This ratio is very important for investors, as they will have to compare between two or more investments – and eventually choose the one with the best outcome. This measurement levels out the volatility that’s currently present in the market and flattens the returns as well, just as if the entire risk of the investment was eliminated.
For example, if an investor is to compare between a high-risk and a low-risk investment, he or she will see that the high-risk one if far more volatile and can decrease much more in value when compared to the low-risk investment.
The Basics of Sharpe Ratio
The Sharpe ratio was created by William F. Sharpe, a Nobel laureate, as a way for people to eliminate the risk component that comes with investing 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 any of the investments they chose to compare. For example, with a given level of volatility, they might consider that the return of an investment is not high enough.
If the investor is not comfortable with that return, he or she will begin to search for other investments, preferably some that have a higher Sharpe ratio.
The Formula of Sharpe Ratio
In order to come up with the Sharpe ratio of a certain investment, we first have to subtract the best available rate of return of a risk-free security from the average rate of return. Then, we’ll note this result for later, as there is a 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 is evaluated based on the risk-free return.
When making an investment, an investor will look for a higher Sharpe ratio, obviously. A ratio that’s less than one is not good, one between 1 and 1.99 is ok, one between 2 and 2.99 is really good, and one that’s higher than 3 is just 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 that say that the data resulted from the Sharpe ratio formula can be easily misinterpreted and, therefore, misleading.