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How can you use the Sharpe ratio to evaluate investment performance?

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If you are an investor, you probably want to know how well your portfolio is performing compared to the market or a benchmark. You also want to know how much risk you are taking for the expected return. One way to measure both aspects is by using the Sharpe ratio, a popular indicator of risk-adjusted return. In this article, you will learn what the Sharpe ratio is, how to calculate it, and how to use it to evaluate investment performance.

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Chris Pollinger

Advisor to the Elite in the Business of Luxury Real Estate
Raj Sukkersudha

Principal & Founder, Denver Capital
Karan Chawla

Ex-Bain | CFA Level II cleared | Business valuation | Equity research | M&A research | CFP

1 What is the Sharpe ratio?

The Sharpe ratio is a formula that compares the excess return of an investment or a portfolio to its standard deviation, which is a measure of volatility or risk. The excess return is the difference between the actual return and the risk-free rate, which is the return of a safe asset like a treasury bill. The higher the Sharpe ratio, the better the investment or portfolio is at generating more return per unit of risk.

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Chris Pollinger

Advisor to the Elite in the Business of Luxury Real Estate
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Certainly! The Sharpe Ratio is a measure used in finance to evaluate the performance of an investment by adjusting for its risk. It's calculated by subtracting the risk-free rate (like a Treasury Bill return) from the investment's return and then dividing this result by the investment's standard deviation, which represents its volatility. Essentially, it tells you how much additional return you're receiving for the extra risk taken over a risk-free investment. A higher Sharpe Ratio indicates a more desirable risk-adjusted return. Investors use it to compare the performance of different investments, understanding that a higher ratio suggests a better investment choice, given the risk level.

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2 How to calculate the Sharpe ratio?

The Sharpe ratio can be calculated by using the formula: Sharpe ratio = (R - Rf) / SD . 'R' is the average annual return of the investment or portfolio, 'Rf' is the average annual risk-free rate, and 'SD' is the annual standard deviation of the investment or portfolio. For instance, if a portfolio has an average annual return of 12% and a standard deviation of 15%, and the risk-free rate is 2%, then the Sharpe ratio of that portfolio is 0.67.

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3 How to interpret the Sharpe ratio?

The Sharpe ratio tells you how much excess return you are earning for every unit of risk you are taking. A higher Sharpe ratio means you are getting more return for the same level of risk, or less risk for the same level of return. A lower Sharpe ratio means you are getting less return for the same level of risk, or more risk for the same level of return.

Generally, a Sharpe ratio above 1 is considered good, a Sharpe ratio above 2 is considered very good, and a Sharpe ratio above 3 is considered excellent. A Sharpe ratio below 1 is considered poor, and a Sharpe ratio below 0 means you are losing money after adjusting for risk.

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Chris Pollinger

Advisor to the Elite in the Business of Luxury Real Estate
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Generally: - Sharpe Ratio > 1: Good risk-adjusted return. The higher the ratio, the better the risk-adjusted performance. - Sharpe Ratio ~ 1: Acceptable for diversified portfolios but can be moderate for high-risk investments. - Sharpe Ratio < 1: Lower risk-adjusted returns, indicating that the investment isn’t yielding enough return for the risk involved. It's essential to compare the Sharpe Ratios of similar investments or portfolios to make meaningful interpretations. Also, consider it alongside other metrics and market conditions for a comprehensive investment assessment.

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4 How to use the Sharpe ratio to evaluate investment performance?

The Sharpe ratio can help you evaluate the performance of different investments or portfolios by comparing their risk-adjusted returns. Ranking and selecting investments or portfolios based on their efficiency and attractiveness is possible, as the higher the Sharpe ratio, the better the investment or portfolio is. You can also adjust your portfolio allocation according to your risk tolerance and return objectives, increasing or decreasing your exposure to higher or lower Sharpe ratio assets depending on your preferences and goals. Moreover, you can monitor and review your portfolio performance over time and against a benchmark, tracking the changes in your Sharpe ratio to see if you are meeting your expectations and targets.

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Karan Chawla

Ex-Bain | CFA Level II cleared | Business valuation | Equity research | M&A research | CFP
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Sharpe ratio greater than 1 is considered good, but this ratio should not be considered on a standalone basis as it assumes that returns are normally distributed however returns follow log normal distribution. It indicates the performance of an investment compared to the return offered by risk free investment. Formula - (Expected return - Risk free rate)/ Standard deviation

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5 What are the limitations of the Sharpe ratio?

The Sharpe ratio is a useful and widely used tool for measuring risk-adjusted return, but it has some limitations that should be acknowledged. For instance, it assumes returns are normally distributed, which may not be accurate since returns can be skewed or have fat tails. Additionally, the Sharpe ratio does not consider the direction or timing of the risk, only measuring its magnitude. Furthermore, it is sensitive to the choice of the risk-free rate, meaning different risk-free rates can result in different Sharpe ratios for the same investment or portfolio. Therefore, it is important to use a consistent and appropriate risk-free rate when comparing different Sharpe ratios.

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Raj Sukkersudha

Principal & Founder, Denver Capital
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It assumes returns follow a normal distribution, which may not always be true in real markets. It also penalises both upside and downside volatility equally, overlooking investor preferences. It relies on historical data, making it sensitive to the chosen time period. The ratio doesn't account for changes in risk over time, potentially misrepresenting a strategy's current risk profile. Lastly, it assumes a risk-free rate, which may not accurately reflect the risk-free environment.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Raj Sukkersudha

Principal & Founder, Denver Capital
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The Sharpe ratio may not provide a comprehensive assessment of investment performance during periods of market stress or financial crises. In such times, traditional metrics like the Sharpe ratio might not fully capture the increased volatility and risk, potentially leading to an underestimation of the actual risk associated with an investment strategy. It's worth considering alternative or supplementary measures when evaluating performance in challenging market conditions.

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How can you use the Sharpe ratio to evaluate investment performance?

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1 What is the Sharpe ratio?

2 How to calculate the Sharpe ratio?

3 How to interpret the Sharpe ratio?

4 How to use the Sharpe ratio to evaluate investment performance?

5 What are the limitations of the Sharpe ratio?

6 Here’s what else to consider

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