Introduction to Sharpe Ratio/Index

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Introduction to Sharpe Ratio/Index

September 1st, 2010 · Dallas TX, USA -

Active investment management demands that investors have a regular check on how their portfolio is performing. Of course, calculating the return on your portfolio is one of the measures to check how the portfolio is performing. However, it is not the only one. For example, if your portfolio has given you a 15% return, you have done a decent job. However, in the same period, if the index has returned 20% then you have actually underperformed. But we don’t know how much risk you have taken to generate that 15% return. So there you see, return on a portfolio does not say a lot. We will introduce you to a very simple and useful ratio to measure the performance of your portfolio performance that will assist you in actively managing your stock investments. The performance measurement technique that we will introduce will help you in not only measuring the return on your portfolio, but also quantify the risk you are taking in order to achieve this return.

Sharpe Ratio

Sharpe Ratio is one of the most popular risk/reward measures when it comes to measuring the performance of your portfolio. Sharpe ratio allows you to calculate how well you have been compensated for the additional risk that you have taken in your portfolio. Basically, Sharpe ratio gives you the risk-adjusted return. A higher Sharpe ratio indicates a better performance than a lower Sharpe ratio. To calculate the Sharpe ratio, you need the expected return of the risk asset, the risk-free rate and the standard deviation of the risky asset.

The risk free rate is generally the return on short-term government bonds, which are considered the safest form of investment. So suppose we have two risk assets, Asset A and Asset B. The expected return on Asset A is 15% and on Asset B is 20%. The risk free rate is 5% and the standard deviation is 5% and 10% for Asset A and Asset B, respectively. Now as per the formula to calculate, the Sharpe ratio, you will find the excess return that the risk asset generates, compared with the risk free rate and then divide it by the standard deviation of the risk asset. So in our example, we divide the excess return of Asset A, which is 10%, by the standard deviation of Asset A, which is 5%. The Sharpe ratio or the risk adjusted return for Asset A is (15-5)/5 = 2. Similarly, the Sharpe ratio or risk adjusted return for Asset B is 1.5.

So there we have it. When we had only the returns of Asset A and Asset B, we would have picked Asset B. However, we did not know the additional risk we were taking to hold Asset B. With Sharpe ratio, we could quantify risk and calculate the risk adjusted return. And based on the Sharpe, we will chose Asset A because we now know that for the additional risk that we are taking Asset A compensates us better than Asset B.

Performance measurements such as Sharpe ratio are very useful when making your investment decision. As an investor, it is not just important for you to know how much return an asset generates, but how much risk you are taking to generate that return. Sharpe ratio is one of simplest tool to find that out.

Tags: Stock Investments