A Sharpe Ratio is used by investors to measure the performance of an investment. It helps to calculate the return of an investment compared to the risk.

What is Sharpe Ratio?

Sharpe Ratio is the difference between the return of an investment and the risk-free return; known as the excess return, divided by the standard deviation of the investment. The investor can determine if the investment fulfils his requirements with the Sharpe Ratio. It adjusts the performance for the excess risk that was taken by the investor. It can be used to evaluate the performance of a share against the risk. Sharpe Ratio can compare two funds that have the same risks or the same returns or to a benchmark, which can help the investor understand how well he will be compensated.

How to calculate Sharpe Ratio?

Sharpe Ratio=​ Rp​−Rf/ Standard Deviation of the fund return

​​where,

Rp​=return of a portfolio,

Rf​=risk-free rate,

The standard deviation shows the relationship between the Sharpe ratio and risk. It is also known as the total risk. If the funds have the same returns, the shares with a higher deviation will have a lower Sharpe Ratio.

Why is Sharpe Ratio important?

The Sharpe Ratio shows how much compensation the investor can get for investing in a risky stock than a risk-free stock. It can be used to estimate the additional profit the investor can make for holding a high-risk asset in the market. If a stock has a high Sharpe ratio, it has better returns relative to the amount of investment risk it has taken. A negative Sharpe ratio can mean the risk-free rate is greater than the stock’s return, or the stock’s return is expected to be negative. In such cases, investing in a risk-free fund is a better option than investing in a risky investment. The Sharpe ratio of a risk-free asset is zero.

In the case of a diverse portfolio, if the assets have low to negative correlation, it may reduce the overall portfolio risk and increase the Sharpe ratio.

Limitations of Sharpe Ratio

If the Sharpe Ratio is used in isolation, it does not give enough information. The ratio has to be calculated by comparing funds to other funds or a benchmark. The standard deviation considers the normal distribution of returns. This is not as beneficial when the distribution is asymmetrical. Sharpe ratio can be manipulated by portfolio managers to boost their risk-adjusted returns history. Sharpe ratio cannot distinguish between upside and downside and focuses on volatility but not its direction. It that price movements in either direction are equally risky.