What is Sharpe Ratio?

A thumb rule for making sound investments is to assess the risk and return of the underlying securities. You will likely achieve your financial goals if you make investments that align with your return expectations and risk tolerance. A popular method that can help you evaluate the risk and return of an investment is the Sharpe Ratio. Developed by American economist William Sharpe, the Sharpe Ratio is used to assess the performance of a particular investment by adjusting its risk. A high ratio indicates a more significant return against the risk level, therefore, a better investment. You can use the Sharpe Ratio to make an informed investment decision. 

Here is everything you should know about Sharpe Ratio: 

What is Sharpe Ratio? 

Sharpe Ratio of an investment, usually mutual funds, indicates the risk-adjusted returns. Risk-adjusted returns of an investment refer to the excess returns generated by a particular investment compared to safe investments, like a fixed deposit. You can use the ratio to assess single security like a stock or a bond or evaluate risk-adjusted returns for an entire portfolio. The higher the ratio, the greater is the return of the security/ portfolio relative to the risk level, indicating a good investment.  

How to calculate Sharpe Ratio? 

You can know the Sharpe Ratio of your security or portfolio in question by using a simple formula. 

Sharpe Ratio = (Rx – Rf)/ StdDev Rx 

Where, 

  • Rx = expected portfolio or security returns 
  • Rf = risk-free rate of return 
  • StdDev Rx = Standard deviation of the security or portfolio returns, also known as volatility 

Volatility defines the fluctuation in the price of an asset or portfolio. 

To know the Sharpe ratio of your investment, such as mutual funds, you can follow these steps: 

Step 1: Subtract the risk-free rate from the portfolio returns. The risk-free rate could be the rate of return on secure investments, such as fixed deposits, government bonds, etc. 

Step 2: Divide the sum in Step 1 by the standard deviation of the excess return of the security or portfolio. Standard deviation measures the divergence of the portfolio’s return from the expected returns. In other terms, it assesses the volatility of the portfolio. 

Thresholds for Sharpe Ratio: 

Less than 1 = Bad investment 

Between 1 and 1.99 = Adequate/good investment 

Between 2-2.99 = Very good investment 

More than 3 = Excellent investment 

How to use the Sharpe Ratio? 

The Sharpe Ratio is one of the most reliable methods to assess the potential risk-adjusted returns of a security or investment portfolio. By using the Sharpe ratio, you can specifically compare profits related to risk-taking activities. The objective is to use the Sharpe ratio to reduce volatility and maximise returns. For instance, if a particular investment, such as a government bond, has an 8% annual rate of return but zero risk or volatility, then the Sharpe Ratio is infinite. However, even government bonds have some risk elements, such as interest rate fluctuations. Hence, the volatility is not zero, and as the interest rate fluctuates, the returns are expected to go up and compensate for the increased risk. 

If the Sharpe ratio is negative, the risk-free return is higher than the portfolio return, or the portfolio return is negative. You can calculate the Sharpe ratio on an annual or monthly basis. In terms of mutual fund investments, you can gauge a mutual fund scheme’s risk associated and adjusted return. You can deduce if the high risk you are taking is generating good returns. 

Further, the Sharpe ratio can also help you compare different investments, specifically mutual funds, and make an informed investment decision. Apart from scheme-to-scheme comparison, you can also use insights from the Sharpe ratio to compare the performance of a mutual fund against the benchmark. To some extent, the Sharpe ratio is also helpful in identifying the level of diversification of a mutual fund portfolio. If you are invested in a scheme with a Sharpe ratio of 2.00, you can add another fund to your portfolio to reduce the risk and increase the returns. 

What are the limitations of using the Sharpe Ratio? 

Overall, the Sharpe ratio is highly useful in evaluating the performance and risk-adjusted returns of a portfolio or investment scheme. However, the ratio has some limitations to it, such as: 

  • The ratio does not indicate if the mutual fund portfolio comprises securities from single or varied sectors. Hence, you do not have in-depth knowledge about the risk level. 
  • The ratio assumes all investments to follow a normal return dispersion method, which is not feasible for all scenarios. 
  • When comparing two mutual funds, the ratio only assesses their risk-adjusted returns. Hence, the Sharpe ratio cannot be used for conclusive decision making. 

In all, you can use the Sharpe ratio as one of the many comparison methods to make a sound investment decision. However, it is beneficial to evaluate investments on a holistic basis. You can use online advanced platforms, like Alphanti, driven by big data and technology to make smart investment choices for a financially secure future.