The Sharpe ratio was developed by the famous US economist William Forsyth Sharpe. In 1990, Forsyth Sharpe, who was awarded the Nobel Prize in Economics, contributed to the creation of the Sharpe ratio as well as the preferred binomial options method of option valuation. The Sharpe ratio is used to determine whether the investments investors are willing to make are worth the risk. It is a ratio used by investors, market experts, and economists to assess and calculate the potential returns on investment (Return on Investment - ROI). The Sharpe ratio is a measure of how well an investment is likely to perform relative to the return measures and rates of risk-free investments such as treasury bonds.
The Sharpe ratio can measure the risk premium of an investment as a proportion of the returns of risk-free investments. The excess return or risk premium is the investment return minus the risk-free rate. The Sharpe ratio is a widely used and preferred tool for measuring risk-adjusted performance.
Sharpe ratios also have several limitations. The first of these limitations assumes that investment returns are normally distributed. However, conditions may not always be favorable to this parameter. Another limitation of the Sharpe ratio is that it does not take into account the downside risks of any investment. But despite these limitations, the Sharpe ratio is one of the most useful tools for calculating the performance of an investment in the context of risk.
The Sharpe ratio is used by market experts and investors to calculate whether an investment is worth taking these risks. In technical terms, the Sharpe ratio is measured as the average return on an investment that goes beyond the risk-free rate per deviation unit of a particular financial instrument. Therefore, if two different financial assets are compared using the Sharpe ratio, the financial asset with a much higher Sharpe ratio is considered better and worth investing in.
What Is a Good Sharpe Ratio?
The Sharpe ratio of 1.0 for an asset in the financial markets is generally considered a good ratio by experts. It is because it indicates that the financial asset in question has a better performance than its volatility. However, investors and experts often compare the Sharpe ratio of portfolios with other peers.
The higher the Sharpe ratio, the more interesting the investment or trading strategy. Moreover, even so-called Ponzi schemes can offer a high Sharpe ratio. But in Ponzi schemes, the data inputs are incorrect. In this case, the returns do not represent the actual returns. It is very important to use the Sharpe ratio correctly and appropriately.
Many banks and large fund managers use the Sharpe ratio along with other financial instruments to measure the performance of their portfolios. The Sharpe ratio is applied in markets such as stock exchanges. Negative values of the Sharpe ratio are not useful in practical terms. It is because the results of the calculation may approach zero when volatility or volatility is very high or in scenarios where returns are constantly increasing.
How to Calculate Sharpe Ratio?
The Sharpe ratio is calculated by subtracting the risk-free rate of return from the investment return and then dividing this number by the standard deviation of investment returns.
Example: An investor has invested in an equity fund for one year. The fund has an annual return of 12% and a risk-free interest rate of 3%. In addition, the annual standard deviation of the fund is 8%.
Calculate the return-risk spread:
Return-risk spread = Fund return - Risk-free interest rate
Return-risk spread = 12% - 3% = 9%
Divide the standard deviation by the risk-free interest rate:
Sharpe ratio = Return-risk spread / Standard deviation
Sharpe ratio = 9% / 8% = 1.125
In this case, it can be said that the investor earned an extra return of 1.125 units for each unit of risk invested in this equity fund during the year.
What Is the Difference Between Sharpe Ratio and Sortino Ratio?
The Sortino ratio is similar to the Sharpe ratio. However, one of the most important differences between the two is that the Sortino ratio takes into account the downside risk of the investment in question. The Sortino ratio is calculated by subtracting risk-free rates of return from investment returns and then dividing these numbers by the standard deviation of the investment's downside returns. The Sharpe ratio is a better measure of risk-adjusted return for evaluating investments with relatively higher returns and risk.
How to Interpret Sharpe Ratio?
Sharpe ratios are open to interpretation. The higher the Sharpe ratio, the better the return on investment relative to risk. The generally accepted interpretations of the values are as follows:
- Acceptable Ratios higher than 1
- Good Ratios higher than 2
- Perfect Ratios of 3 or higher
- Insufficient Ratios below 1
A negative Sharpe ratio means that the risk-free rate is higher than the return on the investment or that the return on the investment is expected to be negative. The Sharpe ratio is an important tool often used by investors and experts.
