Sharpe Ratio Definition
The Sharpe Ratio, named after American economist William F. Sharpe, is a measure used to understand the return of an investment as compared to its risk. This risk-adjusted metric indicates the average return earned over an investment relative to the volatility or total risk undertaken. The higher the Sharpe Ratio, the better the investment’s returns relative to the level of risk involved.
Sharpe Ratio Key Points
- It is a mathematical model to measure risk-adjusted returns of an investment.
- The higher the Sharpe Ratio, the better the investment’s return performance.
- Its application includes cryptocurrency investments along with other traditional asset investments.
- The ratio accounts for the risk-free rate of return in its calculations.
What is Sharpe Ratio?
The Sharpe Ratio is a standard financial metric developed by Nobel Laureate William F. Sharpe. It measures the expected excess return of an investment (over the risk-free rate) per unit of risk, as represented by standard deviation, which is a measure of the investment’s volatility. In essence, the Sharpe Ratio gives you the return you could expect for every unit of risk you undertake.
Why is Sharpe Ratio important?
The Sharpe Ratio is useful for comparing the risk-adjusted performance of various assets or portfolios. Higher ratios show that the returns of the investment are more than its associated risk, which means a better investment. It can be widely adopted across financial instruments including cryptocurrencies by investors to compare their potential risk and reward from different investment opportunities.
Where is Sharpe Ratio used?
Sharpe Ratio has universal acceptance and is used across various types of financial domains which spans from traditional asset classes like equities, bonds, real estate, to more recent and complex asset classes like cryptocurrencies. Funds and portfolio managers also use this risk-adjusted measure to compare their performance against benchmarks.
When is Sharpe Ratio useful?
The Sharpe ratio comes into focus when investors are keen on knowing the risk associated with their investments as compared to the returns. That is, ‘how much risk are they undertaking to achieve their returns’. This notion is very helpful for investors looking to understand their investment’s performance adjusting for the risk involved.
How to calculate Sharpe Ratio?
First, calculate the average rate of return for the investment and subtract the risk-free rate from it. The risk-free rate can be the return of a safe investment such as a government bond. Next, calculate the standard deviation of the investment’s returns, which is a measure of its volatility. Finally, divide the result from the first step by the result from the second step. The result is the Sharpe Ratio. The higher the ratio, the better the investment’s returns when adjusted for risk.
