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Sharpe Ratio

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.

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


Adjusting for risk:: An improved Sharpe ratio
www.sciencedirect.com [PDF]
This paper proposes a new rule for risk adjustment and performance evaluation. This rule is a generalization of the well-known Sharpe ratio criterion, and under normal conditions enables a manager to correctly assess alternative risky investments. The rule is superior to …

Generalised Sharpe ratios and asset pricing in incomplete marketsGeneralised Sharpe ratios and asset pricing in incomplete markets
academic.oup.com [PDF]
This paper proposes a new rule for risk adjustment and performance evaluation. This rule is a generalization of the well-known Sharpe ratio criterion, and under normal conditions enables a manager to correctly assess alternative risky investments. The rule is superior to …

The symmetric downside-risk Sharpe ratioThe symmetric downside-risk Sharpe ratio
jpm.pm-research.com [PDF]
This paper proposes a new rule for risk adjustment and performance evaluation. This rule is a generalization of the well-known Sharpe ratio criterion, and under normal conditions enables a manager to correctly assess alternative risky investments. The rule is superior to …

Beyond Sharpe ratio: Optimal asset allocation using different performance ratiosBeyond Sharpe ratio: Optimal asset allocation using different performance ratios
www.sciencedirect.com [PDF]
This paper proposes a new rule for risk adjustment and performance evaluation. This rule is a generalization of the well-known Sharpe ratio criterion, and under normal conditions enables a manager to correctly assess alternative risky investments. The rule is superior to …

The statistics of Sharpe ratiosThe statistics of Sharpe ratios
www.tandfonline.com [PDF]
This paper proposes a new rule for risk adjustment and performance evaluation. This rule is a generalization of the well-known Sharpe ratio criterion, and under normal conditions enables a manager to correctly assess alternative risky investments. The rule is superior to …

Killing the law of large numbers: Mortality risk premiums and the sharpe ratioKilling the law of large numbers: Mortality risk premiums and the sharpe ratio
onlinelibrary.wiley.com [PDF]
This paper proposes a new rule for risk adjustment and performance evaluation. This rule is a generalization of the well-known Sharpe ratio criterion, and under normal conditions enables a manager to correctly assess alternative risky investments. The rule is superior to …

On testing the equality of the multiple Sharpe Ratios, with application on the evaluation of iSharesOn testing the equality of the multiple Sharpe Ratios, with application on the evaluation of iShares
papers.ssrn.com [PDF]
This paper proposes a new rule for risk adjustment and performance evaluation. This rule is a generalization of the well-known Sharpe ratio criterion, and under normal conditions enables a manager to correctly assess alternative risky investments. The rule is superior to …

Beyond the Sharpe ratio: An application of the Aumann–Serrano index to performance measurementBeyond the Sharpe ratio: An application of the Aumann–Serrano index to performance measurement
www.sciencedirect.com [PDF]
This paper proposes a new rule for risk adjustment and performance evaluation. This rule is a generalization of the well-known Sharpe ratio criterion, and under normal conditions enables a manager to correctly assess alternative risky investments. The rule is superior to …

Portfolio performance evaluation with generalized Sharpe ratios: Beyond the mean and variancePortfolio performance evaluation with generalized Sharpe ratios: Beyond the mean and variance
www.sciencedirect.com [PDF]
This paper proposes a new rule for risk adjustment and performance evaluation. This rule is a generalization of the well-known Sharpe ratio criterion, and under normal conditions enables a manager to correctly assess alternative risky investments. The rule is superior to …



Q&A About Sharpe Ratio


What does Standard Deviation represent?

Standard Deviation represents volatility or risk of an investment.

Why do we divide the answer by Standard Deviation?

We divide the answer by Standard Deviation because it is used as a multiplier for calculating the ratio.

How can you interpret a high Sharpe Ratio?

A high Sharpe ratio indicates that there has been more return on investment with less risk than another fund with lower ratios. This means that investors will be getting more bang for their buck with higher ratios, which makes them better investments overall. It also means that these funds have done well in terms of minimizing risks while maintaining good rates of return over time, which is what most investors look for when choosing where to invest their money long-term. However, it should be noted that just because one fund has a higher ratio than another doesn't mean that it's necessarily a better investment option; other factors such as fees and expenses may make one option preferable over another despite having lower ratios overall. For example, if two different mutual funds both have similar strategies but one charges significantly higher fees than the other, then even though its ratios might be slightly worse overall, it could still end up being a better investment choice due to its lower costs relative to its competitor's fees; however, this would depend on how much each investor values his or her own time and ability

How are funds returns calculated in the Sharpe Ratio?

Funds returns are calculated by subtracting Treasury bill (9 days) from fund return and dividing this answer by standard deviation.

What is the Sharpe Ratio?

The Sharpe ratio is a measure of risk-adjusted performance.

What does the Sharpe Ratio use to determine returns?

The Sharpe ratio uses standard deviation to determine returns.

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