What is Sharpe Ratio?
The Sharpe ratio, also known as Reward-to-Volatility-Ratio, measures the risk-adjusted performance. This ratio has been named after William F. Sharpe who developed this ratio. It indicates the excess return per unit of risk associated with the excess return. The higher the Sharpe Ratio, the better the performance.
How it is calculated?
It is calculated by subtracting the risk-free rate from the rate of return for a portfolio and dividing the result by the standard deviation of the portfolio returns.
SR = {r - rf} / v
Where
SR - Sharpe ratio
R - Portfolio return
RF – Risk free rate
V - Portfolio volatility
For example: Your investor gets 7 per cent return on her investment in a scheme with a standard deviation/volatility of 0.5. We assume risk free rate is 5 per cent.
Sharpe Ratio is 7-5/0.5 = 4 in this case.
What does Sharpe Ratio signify to the investors?
The greater a portfolio's Sharpe Ratio, the better its risk-adjusted performance. A negative Sharpe Ratio indicates that a risk-less asset would perform better than the security being analyzed.
Why this ratio is considered important while investing?
This measurement is very useful because it explains why one portfolio has reaped higher returns than its peers; it is only a good investment if those higher returns do not come with too much additional risk.
Risk-adjusted financial performance of investment portfolios or mutual funds is typically measured by Sharpe's ratio. From an investor's point of view, the ratio describes how well the return of an investment compensates the investor for the risk he takes.