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Today, we explore the influential metric known as the Sharpe Ratio. This measure is useful to both retail investors and institutional investors who want to assess risk-adjusted returns for more volatile assets. So, with that goal in mind, let's level up our inner metrician and unlock the power of the Sharpe Ratio.
Named after its creator, Nobel laureate William F. Sharpe, the Sharpe Ratio a statistical tool that quantifies the risk-adjusted return of an investment or portfolio. This metric enables investors to gauge the excess return generated per unit of risk taken: that means we consider both return, or how much our money grew, and volatility, how often and how quickly the price changed from day to day. Just like you want to get more bang for your buck, we’re trying to get more return for every off-day where we might have to withdraw at a loss. The Sharpe Ratio provides a comprehensive assessment of investment performance, factoring in the level of risk involved.
The formula for calculating the Sharpe Ratio is relatively straightforward. It involves subtracting the risk-free rate of return from the investment's average return, and then dividing the result by the standard deviation of the investment's returns. The resulting figure represents the excess return per unit of risk taken, where a higher Sharpe Ratio indicates a more favorable risk-adjusted return.
This is because a higher Sharpe Ratio implies a better risk-adjusted performance, as the investment generated a higher excess return relative to its volatility, or price movement. Conversely, a lower Sharpe Ratio suggests that the investment has underperformed compared to its risk level.
The risk-free rate plays a crucial role in the calculation of the Sharpe Ratio. It represents the hypothetical return an investor would earn by investing in a risk-free asset, such as Treasury bonds; they’re risk-free to the extent that if the US government were to default on its debts such that your bonds became worthless, the world would have much bigger problems than your investment returns.The risk-free rate serves as a benchmark against which investors measure the excess return earned by taking on additional risk.
If you want to see the calculation for yourself Forbes has this breakdown:
Sharpe Ratio = (Rp – Rf) / Standard deviation
Rp is the expected return (or actual return for historical calculations) on the asset or the portfolio being measured.
Rf is the risk-free rate, which is often a U.S. Treasury bill of short maturity. However, some analysts suggest that the Treasury used should be of similar duration to the investment(s).
Standard deviation is a measure of risk based on volatility. The lower the standard deviation, the less risk and the higher the Sharpe ratio, all else being equal. Conversely, the higher the standard deviation, the more risk and the lower the Sharpe ratio.
The market risk premium is represented by the (Rp – Rf) part of the formula. This is the excess return above the risk-free rate.
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