Sharpe Ratio
The Sharpe Ratio is a measure used to assess the risk-adjusted return of an investment or portfolio. It is calculated by subtracting the risk-free rate of return from the expected return of the investment and then dividing the result by the standard deviation of the investment’s Returns. The formula is:
Sharpe Ratio = (Expected Return – Risk-Free Rate) / Standard Deviation of Return
A higher Sharpe Ratio indicates better risk-adjusted performance.
Example: If an investment has an expected return of 8%, a risk-free rate of 2%, and a standard deviation of 10%, the Sharpe Ratio would be:
Sharpe Ratio = (8% – 2%) / 10% = 0.6
Case: Consider two portfolios: Portfolio A has an expected return of 10% with a standard deviation of 15%, and Portfolio B has an expected return of 12% with a standard deviation of 20%. If the risk-free rate is 3%, the Sharpe Ratios would be:
Portfolio A: Sharpe Ratio = (10% – 3%) / 15% = 0.4667
Portfolio B: Sharpe Ratio = (12% – 3%) / 20% = 0.45
Despite Portfolio B having a higher expected return, Portfolio A has a better Sharpe Ratio, indicating it provides a better risk-adjusted return.