FINANCIAL TOOL
Sharpe Ratio
This equation attempts to measure risk-adjusted performance for an investment.
Basically, how many units of return have been achieved for each unit of risk?
It’s like saying, “How much did this return cost me?” It’s a reasonable question to ask!
After all, we don’t want to pay with any more risk than absolutely necessary for the returns we’re seeking!
Here’s the technical definition:
Sharpe Ratio =
Return of the asset – (Risk-free rate)
Standard deviation of the asset’s return
Is it a perfect measurement? No.
Weaknesses in this method of risk-reward comparison include:
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- Standard deviation measures movement on both the up and downside of price return. That means it includes good risk (when price goes up) along with downside risk.
- Standard deviation is not the only way to measure risk; it’s just a popular way because it can be easily measured.
- This only measures past numbers which are not predictors of what they will be in the future.
Despite its weaknesses, it is a fast way to get a snapshot of how one investment compares with another in historical returns per unit of risk taken.