Risk and reward should be considered while investing or trading. The Sharpe Ratio measures investment risk-adjusted return. Developed by Nobel laureate William F. Sharpe, this ratio is crucial for traders and investors.
Sharpe ratio?
Investors see their return per risk via the Sharpe Ratio. Comparison of an investment’s excess return (return above risk-free rate) to volatility or risk. This evaluates investment returns depending on risk.
Sharpe Ratio Formula:
investment return – risk-free rate / standard deviation
One number compares investing risk and return: the Sharpe Ratio. Investment selection benefits from higher Sharpe Ratios, which indicate better risk-adjusted returns.
Interpreting Sharpe Ratio
Considerations for using the Sharpe Ratio to analyze investments:
Positive Sharpe Ratio investments outperform risk-free ones. High ratios indicate better risk-adjusted returns.
A negative Sharpe Ratio means an investment doesn’t reward risk. Alternative investments may be wise.
Compare Sharpe Ratios to get the best risk-adjusted return. The Sharpe Ratio should not be the only criterion for investing. One of numerous factors.
Limits on sharp ratio
The Sharpe Ratio provides risk-adjusted return insights, but it has limitations:
Sharpe Ratio assumes investment returns are regularly distributed, which may not be true.
It assesses investment return volatility or standard deviation without considering additional risks.
The Sharpe Ratio may misrepresent investors with different risk tolerances.
Conclusion
Trading beginners must understand risk and profit. Simple and effective, the Sharpe Ratio assesses investment risk-adjusted return. Sharpe Ratios help you make smarter decisions and locate the best risk-return choices.
References and sources:
Accessed at https://www.investopedia.com/terms/s/sharperatio.asp
The Sharpe ratio is on Wikipedia.
According to Nasdaq, “The Sharpe Ratio: A Guide for New Investors” (2018-07-18).