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Investors are often confused when it comes to choosing between risk-free assets or high-risk investments. While high-risk investments can provide higher returns, they also come with a higher risk of loss. Sharpe ratio is one such tool that helps investors evaluate how much extra return they can earn if they hold a high-risk asset. This guide covers the meaning of the Sharpe ratio, the Sharpe ratio formula, limitations, and a lot more.
Sharpe ratio is a statistical tool to measure the risk-adjusted returns potential of a mutual fund. Risk-adjusted return is the return earned over and above the returns generated by a risk-free asset like a Government bond or a Fixed Deposit. The excess returns are in comparison to the extra risk taken by the investors by investing in a risky asset like equity funds.
The risk in an investment can be determined using the standard deviation. A higher Sharpe ratio indicates better chances of yielding a higher return for every additional unit of risk taken by an investor. This justifies the volatility of the fund and can be used to compare funds.
Sharpe ratio indicates investors’ desire to earn returns over and above those provided by risk-free instruments like treasury bills. Since the Sharpe ratio relies on standard deviation, a measure of the overall risk associated with an investment, it effectively communicates the level of returns an investment produces, considering various risks. This ratio plays a very important role in evaluating fund performance.
The Sharpe ratio is computed by deducting the risk-free return from the portfolio return, also known as the excess return. After this, any excess return is divided by the standard deviation of the portfolio returns. The purpose is to measure the additional return for each extra unit of risk assumed. Typically, this calculation is performed monthly and then annualized for simplicity.
The formula for calculating the Sharpe Ratio is as follows:
Sharpe Ratio= (Average fund returns − Riskfree Rate) / Standard Deviation of fund returns
For instance, if a fund's Sharpe ratio is 1.25 per annum, it implies the fund generates an extra 1.25% return for every 1% increase in annual volatility. A fund with a higher standard deviation must achieve greater returns to maintain a higher Sharpe ratio. Conversely, a fund with a lower standard deviation can attain a higher Sharpe ratio by consistently earning moderate returns.
Let's compare two investment portfolios: Portfolio A is expected to make a return of 14% in the next year, while Portfolio B is expected to make a return of 11% in the same time frame. If we only look at returns without considering risk, Portfolio A seems better.
Now, let's consider risk using the Sharpe ratio, which gives a broader view. In this example, Portfolio A has more risk (standard deviation of 8%), and Portfolio B has less risk (standard deviation of 4%). The risk-free rate is 3%.
Calculating the Sharpe Ratio for each:
Despite Portfolio A having more volatility, its Sharpe ratio is lower than Portfolio B's. This means that, with a Sharpe ratio of 2, Portfolio B offers a better return when considering risk.
Generally, a Sharpe ratio between 1 and 2 is good, between 2 and 3 is very good, and anything above 3 is excellent.
Despite its benefits, the Sharpe ratio also comes with its own set of limitations. Given below are some of these -
Sharpe Ratio proves to be a valuable tool for investors seeking a balanced view of risk and return. While it provides insights into a fund's performance against risk, it's essential to consider its limitations. The ratio's ability to guide fund selection, analyze diversification, and reveal the optimum risk-return tradeoff is significant. Remember, the Sharpe ratio is just one facet of comprehensive fund evaluation. You must use other qualitative measures along with it to maximize the efficiency of decision-making.
