The Sharpe Ratio is a widely used metric to evaluate investment performance, considering both returns and risk. Developed by William F. Sharpe, it helps investors understand the relationship between risk and return.
The Sharpe Ratio measures excess return. It asks: "How much extra profit am I making for the extra risk I'm taking compared to just sitting on my cash in a safe investment (like a Bank Savings Account)?"
Sharpe Ratio = (Rp - Rf) / σp
- Rp: Expected portfolio return
- Rf: Risk-free rate (e.g., government bond yield)
- σp: Standard deviation of portfolio returns (volatility)
Insights:
- Risk-adjusted returns: Compares returns relative to risk taken.
- Volatility: Penalizes investments with high volatility.
- Comparisons: Useful for comparing different investments or portfolios.
Examples:
Portfolio A: 10% return, 15% volatility, Rf = 5%
Sharpe Ratio = (10% - 5%) / 15% = 0.33
Portfolio B: 12% return, 20% volatility, Rf = 5%
Sharpe Ratio = (12% - 5%) / 20% = 0.35
Portfolio B has a slightly better risk-adjusted return.
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In the world of investing, a higher Sharpe Ratio is generally considered "better" because it means you are getting more return for every unit of volatility you endure. However, there are some nuances to keep in mind regarding what is considered "good" and when a high ratio might actually be a red flag.
Typical Ranges for Sharpe Ratio:
Generally, these are the benchmarks used by portfolio managers to evaluate performance:
- Under 1.0: Suboptimal: You aren't being compensated well for the volatility you're taking on.
- 1.0 to 1.99: Good: This is a solid, respectable ratio for a diversified portfolio.
- 2.0 to 2.99: Very Good: This is often the "sweet spot" for high-performing hedge funds or professional traders.
- 3.0 or higher: Excellent/Exceptional. Sustaining a Sharpe Ratio above 3.0 over a long period is extremely rare and difficult.
