What is Sharpe Ratio

What is Sharpe Ratio

Sharpe ratio calculates the expected return over the risk-free rate existing in the market for each unit of deviation of the combined portfolio

Sharpe Ratio

Sharpe ratio is a financial term which helps investors to understand the risk and return of an investment, over the risk-free return of the market for every unit of standard deviation within the portfolio chosen to invest in.

A portfolio is a collection of different types of investments such as bonds, shares, mutual funds etc. in which investors expect maximum amount of return with the minimum risk allotted against the investment. The average expected return of a portfolio may be high but it comes along with a certain amount of risk which is limited to the total amount of money invested in it.

For investing in a portfolio different weightings are assigned to each individual investments depending upon the risk and the returns an investor is looking for in the market. The Sharpe ratio helps the investor to examine how much return the portfolio gives over risk-free investment plans such as treasury bills, government bonds etc. for each deviation existing within the selected portfolio.

Sharpe Ratio = (RP-RF) / Std Deviation

Where

RP is the expected return of a portfolio

RF is the risk-free investment rate

Suppose we consider an expected return on a portfolio is 8%, the risk-free rate existing is 4.5% and the distance of the returns from the portfolio mean is 0.08.

Here

RP = 8%

RF = 4.5%

Std Deviation = 0.08

Sharpe Ratio = (8% – 4.5%)/ 0.08

Sharpe Ratio = 0.437

Generally, Sharpe ratio of more than 1 is considered to be good but depending upon the investment plan investor may allow different weights and consider different risk and rewards which may tend to depend upon their investment plans.