Sharpe Ratio

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Definition

In finance, the Sharpe ratio is a way to examine the performance of an investment by adjusting for its risk. The ratio measures the excess return per unit of deviation in an investment asset or a trading strategy, typically referred to as risk, named after William F. Sharpe.

Sharpe Ratio

The great Nobel Laureate William Sharpe is the name behind the concept of Sharpe Ratio. The term is used by financial analysts and investors to derive the returns that are risk adjusted. Standard deviation is used in this process. Under this concept, the more the funds Sharpe ratio, the better are the returns promised on the risk it has taken.

It computes a fund’s return on the investments made, that are guaranteed to be risk free investments corresponding to its Standard deviation.

How to calculate a Sharpe ratio?

Sharpe ratios are based on the treasury bill of 90 days. This is in relation to the standard deviation. In calculating the ratios, the first step is to deduct any returns from the Treasury bill (90 days) from the returns of the funds.

For example: A fund has returned 25% , at 10% SD (standard deviation) , with the treasury bill with 5% returns. So, for the Sharpe ratio we subtract the 25 from the 5 of treasury bills returns and divide the answer (20) with the SD at 10. This leaves us with 2. Hence, our Sharpe ratio is at 2.

As discussed earlier, the more accelerated the ratios would be, better the returns. This is in regard to the risks associated, In the same way, the higher the funds SD, the funds return need to be higher so that a higher Sharpe ratio is also earned.

Funds that have very low SD can also have higher Sharpe ratios if they have persistent returns.

A useful tool for comparisons:

Financial advisors and investors make use of Sharpe ratios for comparing funds that have similar strategies. For example, there can be two different funds with identical returns. However, there will be various ways of getting there. For this reason, the Sharpe ratio can help to identify with investments issues, such as which fund is more prone to risks.

It is also advised by financial professionals that Sharpe ratio works best when estimated for at least 3 years. This is because the fund’s performance is risk adjusted, so an insight into many years (preferably 3-4) can evaluate how the fund performed in fluctuating market environments. This will further help investors to mould strategies that will fulfill their return needs.

The concept is most commonly used in calculating the risk-adjusted returns. But, if applied to the portfolios or assets, it can be inaccurate. Fr such options. You can use alternative methods such as the Treynor Ratio.

Further Reading

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