Sharpe Investing

Answer 1

Have you heard of the Sharpe Ratio? The Sharpe Ratio is a measure of the risk-adjusted return of an asset or a portfolio of assets.

The Sharpe Ratio can be used to compare investment strategies or managers, taking into account the amount of risk exposure each has in relation to their returns.

William Forsyth Sharpe created the ratio in 1966. He would later develop the Capital Asset Pricing Model (CAPM) for which he would win the Nobel Prize in Economics.

The Sharpe Ratio is calculated by dividing the difference between the average return for the portfolio and the risk-free rate of return by the standard deviation of returns for the portfolio.

The formula looks like:

S(x) = (Rx – Rf) / StdDev(x)

Where x = portfolio, Rx = average returns of portfolio, Rf = risk-free rate of return, and StdDev(x) = the standard deviation of returns for x.

So how do you go about using this tool? First, it’s important to remember that, just like any other number derived from a formula you use to evaluate investments, The Sharpe Ratio can act as a guide, but should not be used in a vacuum. There are always many things to consider when investing.

The Sharpe ratio can give you some idea of the efficiency of a portfolio by showing the amount of return generated per unit of risk assumed.

The higher the Sharpe Ratio the better relationship of reward to risk the portfolio is deemed to have.

Because the Sharpe Ratio takes volatility of a portfolio into account in its analysis its use is helpful when comparing different investment strategies or managers.

All other things being equal (i.e. rate of return, constant risk-free rate) the strategy or manager exhibiting the highest return with the lowest amount of risk (as measured by standard deviation) would be the better choice.