Sharpe Ratio
The ratio compares investment return to risk. The greater this ratio, the lower will be the risk for return.
What is the Sharpe Ratio?
The Sharpe ratio compares investment return to risk. The greater this ratio, the lower will be the risk for return. The standard deviation is used to calculate volatility or risk. The greater our return and the lower our risk, the greater will be our ratio.
The Sharpe ratio decreases when risk grows without an equal or larger increase in return, indicating that we are taking on more risk for each unit of return. Therefore, when comparing investments, it is also critical to compare ratios across them.
A benchmark, like the risk-free rate of return, is used as the numerator of the Sharpe ratio, which measures the difference over time between realized or anticipated returns and that benchmark.
As a gauge of volatility and risk, it uses the standard deviation of returns over the same time period as its denominator.
Key Takeaways
- To estimate risk-adjusted performance, the Sharpe ratio divides an entire portfolio's anomalous profit by a measure of its variation.
- Risk returns are returns above an industry benchmark or the risk-free rate of return.
- The calculation of the ratio could be based on past performance or projections.
- When comparing similar portfolios, a greater ratio is preferable.
- For some investment methods, the ratio may be inflated and has intrinsic flaws.
Formula and Calculation of the Sharpe Ratio
The ratio is calculated as follows:
Sharpe Ratio = [Expected Portfolio Return - Risk Free Rate]/ Portfolio Standard Deviation
The higher the ratio, the higher the investment return compared to the risk incurred, and hence the better the investment. The ratio can be applied to a single stock, investment, or an entire portfolio.
The goal is to maximize profits while minimizing volatility. For example, if an investment had a 10% yearly return but no volatility, its Ratio would be infinite (or undefined). But, even with a government bond, 0% volatility is unattainable (prices go up and down).
If volatility grows, the expected return has to increase considerably to compensate for that added risk.
The Sharpe ratio was created in 1966 by William F. Sharpe as an extension of his work in the Capital Asset Pricing Model (CAPM). William F. Sharpe was awarded the Nobel Prize in Economics in 1990 for his work on CAPM.
Use of Sharpe Ratio
An investment portfolio may include stocks, bonds, ETFs, deposits, precious metals, or other securities. Each security has its underlying risk-return level, which determines the ratio.
For example, let's assume a fund manager owns a stock portfolio with a ratio of 1.60. The fund management adds additional commodities to diversify the portfolio and changes the composition to 80% stocks and 20% commodities, raising the ratio to 1.90.
While the portfolio change may increase the total amount of risk, it raises the ratio, suggesting a more favorable risk/reward position.
If the portfolio change caused the ratio to fall, the portfolio addition, while possibly generating excellent returns, would be viewed as having an unacceptable amount of risk by many financial experts, and the portfolio change would be avoided.
There are 2 competitive objectives of investors:
- They always strive to maximize the returns on their assets.
- They seek to reduce risk, meaning they desire as little danger as possible of experience financial loss.
The Sharpe Ratio calculates investors' risk-adjusted returns and assigns them a score. This important financial ratio can be used to assess previous performance or anticipated future performance.
But in both cases, it aids the investor in determining whether the gains are the result of wise choices or just taking on too much risk. If it's the latter, when market circumstances shift, investors can lose more money than they can afford.
The Sharpe Ratio is essential for producing returns and spotting risk in mutual funds. It assists investors in determining the risk level and adjusted return rate of each mutual fund.
Note
With the Sharpe Ratio, investors may determine the degree of risk associated with each fund in contrast to the additional returns. It mostly examines mutual fund operations with growth and value strategies.
Sharpe Ratio Pitfalls
It's crucial to remember that the equation assumes that the average returns on an investment are regularly distributed over a curve. With a normal distribution, most returns are symmetrically clustered around the mean, and the curve's tails contain fewer returns.
However, normal distributions do not adequately capture the reality of financial markets. Investment returns do not exhibit a normal distribution over the near term.
While the distribution of returns on a curve clusters near the tails, market volatility can vary greatly. As a result, the standard deviation may be less useful as a risk indicator.
A ratio that is either larger or lower than it should be might occur when the standard deviation misrepresents the risk taken.
The ratio also comes with some limitations. For example, when evaluating symmetrical probability distribution curves, the ratio's standard deviation calculation — which serves as a proxy for portfolio risk — is most useful since it computes volatility using a normal distribution.
The ratio considers the past distribution of returns and volatility. As a result, the ratio offers no indication or projection of future risks or returns.
Leverage is a type of debt that investors take on to raise their potential investment returns. Debt usage raises an investment's adverse risks.
Note
The ratio will drop sharply, and any losses will be much worse if the standard deviation increases too much, which might result in the investor receiving a margin call.
Overall, some of the ratio's drawbacks are listed below:
1. Although various funds may have distinct dispersion patterns, it just assumes that all investments have a typical pattern for the distribution of returns.
2. A fund's Sharpe Ratio does not assume any liability for managing portfolio risks and does not indicate if the fund is addressing one or more concerns.
3. A mutual fund's Ratio is utilized for evaluation, which is viewed as misleading and a poor tactic, as it doesn't show if the fund had been through a bad period recently.
4. The Ratio is influenced by the portfolio managers. By extending the time horizon used to calculate the ratio, they might attempt to increase their adjusted risk-free returns.
Sharpe Alternatives: The Sortino and the Treynor
The calculation for the ratio assumes that price changes in both directions are equally dangerous. For most investors and analysts, the danger of an unusually low return differs greatly from the potential of an extraordinarily large return.
Some of the alternative ratios to the Sharpe ratio for calculating the risk associated with the funds are as follows:
1. Sortino Ratio
The Sortino Ratio calculates a scheme's risk-adjusted returns and works effectively for cautious retail investors. The Sortino ratio clearly shows how well a scheme's fund manager has been able to contain downside volatility, or returns that fall below-average returns, and produce promising gains.
Note
The Sortino Ratio (SR) gauges a particular scheme's risk-adjusted return.
In summary, SR provides a clear picture of how well a scheme's fund manager has managed to produce promising returns while limiting a scheme's downside volatility, which may result in returns that fall below-average returns.
2. Treynor Ratio
The reward-to-volatility ratio, also known as the Treynor ratio, gauges how much extra return a portfolio generates per unit of associated risk. Any investment return that exceeds what it might have earned in a risk-free environment is known as an excess return.
The Treynor ratio commonly employs treasury bills to simulate a risk-free return, even though no investment is actually risk-free. The beta of the portfolio — a measurement of the overall systematic risk of an investment portfolio — determines risk.
or Want to Sign up with your social account?