Sharpe Ratio 📐🏎️
Developed by Nobel laureate William Sharpe, the Sharpe Ratio is the most widely used measure of risk-adjusted return in the world. It tells you how much "Extra Return" you got for every unit of Total Risk you took.
1. The Sharpe Equation
The formula is simple:
Sharpe Ratio = (Rp - Rf) / Sp
Where:
- Rp: Return of the portfolio.
- Rf: Risk-Free rate.
- Sp: Standard Deviation of the portfolio (Total Risk).
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2. Interpreting the Result
The Sharpe Ratio measures the Slope of the line from the risk-free rate to your portfolio.
- A higher Sharpe Ratio is always better. It means you are getting more return for the same amount of risk.
- Sharpe Ratio > 1.0: Generally considered "Good."
- Sharpe Ratio > 2.0: Considered "Very Good."
- Negative Sharpe Ratio: Means your portfolio did worse than a risk-free bond (bad result!).
3. When to use Sharpe Ratio?
Since the Sharpe Ratio uses Standard Deviation (Total Risk), it is the best measure to use for:
- Undiversified Portfolios: If you own only 2-3 stocks, you need to care about total risk.
- Comparing Multi-Asset Portfolios: Comparing a mix of stocks, bonds, and gold.
Important
The Sharpe Ratio is often called the Reward-to-Variability Ratio. It rewards "Smooth" performance and punishes "Wild" volatility.
Summary
- Sharpe Ratio uses Total Risk (Standard Deviation).
- It measures the return earned per unit of volatility.
- Higher is better.
- It is the standard tool used by morningstar and other fund rating agencies to give "Stars" to mutual funds.
Quiz Time! 🎯
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