Sharpe ratio

Sharpe ratio

Investing is a field fraught with danger and opportunity. Investors and analysts use a variety of methods in this complicated environment to assess the viability of various investment possibilities. The sharpe ratio is one of these instruments that stands out because it provides a quantitative evaluation of the return on an investment in proportion to its risk. Here, we look at its fundamentals, methodology, importance, and inherent constraints. 

What is sharpe ratio? 

The sharpe ratio, christened after its creator, Nobel laureate William F. Sharpe, is a financial metric that provides investors with a numerical measure of an investment’s risk-adjusted return. In essence, it quantifies whether an investment’s potential return compensates for the inherent risk it entails. This ratio is particularly invaluable in situations where different investment opportunities possess distinct levels of risk. 

The sharpe ratio is fundamentally a barometer of investing caution, a reliable indicator of whether the profit an investment offers is worth the risk it involves. Through this ratio, the proverb “higher the risk, higher the reward” finds an appropriate translation. The sharpe ratio is the prelude of balance rather than just serving as a herald of absolutes. 

The intellect of William F. Sharpe, who saw that investments, like two-edged swords, including both the possibility of gain and the spectre of loss, gave rise to this financial lodestar. The responsibility of measuring this complex balance falls to the sharpe ratio. It gives investors a clear picture of an investment’s past performance so they can assess its historical return to risk. 

Understanding the sharpe ratio 

The duality of risk and reward forms the basis for comprehending the sharpe ratio. Although a larger return is preferred, it must be carefully compared to the risk taken to get that return. The sharpe ratio captures this delicate balance by determining if the return on an investment is reasonable compared to its risk. 

Analysing the sharpe ratio’s constituent parts and ramifications is crucial to understanding its importance. This ratio, at its heart, captures the interaction between risk and return, a basic tenet of finance. Risk in the context of investments refers to the possibility that the actual returns on an investment may differ from those anticipated. On the other hand, reward refers to the returns a shareholder anticipates. 

The sharpe ratio steps into this narrative by acting as an arbitrator between these two realms. It seeks to answer a pivotal question: Does the potential extra return of an investment adequately compensate for the additional risk it entails? In this pursuit, the ratio ushers in the concept of risk-adjusted return, a paramount concept that aligns more intuitively with investors’ concerns. 

Imagine two investments, each boasting the same average return. However, upon closer inspection, one investment exhibits higher volatility, causing its returns to oscillate wildly. The sharpe ratio discerns this difference and translates it into a numerical language. It acknowledges that investors don’t just chase high returns; they chase returns that come with a level of predictability and stability. 

Consequently, the sharpe ratio unveils a layer of sophistication in investment evaluation. It imparts a numerical weight to the intuitive understanding that investments with less risk relative to their return are often more enticing. By quantifying this relationship, it arms investors with a discerning lens to analyse investment prospects more comprehensively. 

Formula for the sharpe ratio 

The mathematical formulation of the sharpe ratio is elegant. It is the difference between the average return of the investment and the risk-free rate, divided by the used methods mathematically: 

Sharpe ratio = (Ra − Rf) / σa

 

 Where, 

Ra is the average return of the investment. 

Rf is the risk-free rate, typically represented by the yield on government bonds. 

 σa  is the standard deviation of the investment’s returns, denoting its volatility. 

Calculation of sharpe ratio 

Let us suppose an investment has an average return of 10%, the risk-free rate is 2%, and its standard deviation is 15%. The sharpe ratio for this investment would be calculated as follows: 

Sharpe ratio =  0.10 − 0.020.15

                        = 0.53 

Importance of the sharpe ratio 

The sharpe ratio provides a comprehensive metric to compare and contrast the risk-adjusted returns of different investment opportunities. By standardising the evaluation process, it aids investors in making informed decisions by considering both the potential return and the risk associated with an investment. 

Frequently Asked Questions

Take into account Option A, which offers an average return of 8%, and Option B, which offers an average return of 12%. The sharpe ratios for Option A and Option B would be 0.50 and 0.90, respectively, if the risk-free rate is 3% and the standard deviations for both options are 10%. This suggests that Option B has a larger return after adjusting for risk. 

A higher sharpe ratio generally indicates a better risk-adjusted return. However, the interpretation of what is considered “good” is based on the risk of the investor. As a rule of thumb, a sharpe ratio above 1 is often deemed satisfactory. 

Collect historical return information for the investment, establish the risk-free rate, then compute the investment’s standard deviation to calculate the sharpe ratio. Apply the above given sharpe ratio formula after that. 

The sharpe ratio is a popular financial tool for calculating the risk-adjusted return on an investment or portfolio. Its benefits include offering a single, simple statistic that allows investors to gauge the success of an investment. It considers both profits and risk, allowing for comparisons of investments with varying levels of risk. Sharpe Ratios with higher values suggest greater risk-adjusted returns, which aids decision-making. Furthermore, it encourages investors to think about risk and reward, advocating a more balanced approach to portfolio management. Due to its simplicity and emphasis on risk-adjusted returns, this measure is a great tool for optimising investment portfolios. 

  • Dependency on Historical Data: The sharpe ratio hinges on historical data, assuming that the future will mimic the past. This assumption can falter during times of market upheaval. 
  • Neglects Non-Normal Distributions: The ratio presupposes a normal distribution of returns, which may not hold true for all investments. 
  • Ignores Investment Horizon: The sharpe ratio fails to consider the time horizon of investments, potentially misleading long-term investors. 

Related Terms

    Read the Latest Market Journal

    Financial Sectors Thriving: Top Traded Counters in April 2024

    Published on May 21, 2024 69 

    At a glance: The Federal Reserve (Fed) held interest rates steady at 5.25% to 5.5%...

    One Dollar at a Time: The Potential of Fractional Shares

    Published on May 20, 2024 68 

    Table of contents 1. Introduction 2. Dollar-Cost Averaging 3. Popularity of Dollar-Cost Averaging 4. Small...

    Unit Trusts vs Exchange Traded Funds (ETFs) – Which is better for your portfolio?

    Published on May 20, 2024 69 

    Imagine you are dining at a nice restaurant, feeling overwhelmed by the variety of seemingly...

    Weekly Updates 20/5/24 – 24/5/24

    Published on May 20, 2024 20 

    This weekly update is designed to help you stay informed and relate economic and company...

    What is CFD? With 2 Practical Examples

    Published on May 15, 2024 105 

    In this article, you will learn what CFD (Contract for Difference) is, the costs and...

    What is ESG investing, and why is it important?

    Published on May 15, 2024 104 

    Over the last five years, Environmental, Social, and Governance (ESG) investing has evolved from being...

    What are fixed-income funds?

    Published on May 15, 2024 59 

    In the diverse world of unit trusts, various funds employ distinct investment strategies aligned with...

    Hong Kong Value Stocks Q2 2024

    Published on May 14, 2024 133 

    After a long period of sluggishness, Hong Kong market has begun to pick up. The...

    Contact us to Open an Account

    Need Assistance? Share your Details and we’ll get back to you

    IMPORTANT INFORMATION

    This material is provided by Phillip Capital Management (S) Ltd (“PCM”) for general information only and does not constitute a recommendation, an offer to sell, or a solicitation of any offer to invest in any of the exchange-traded fund (“ETF”) or the unit trust (“Products”) mentioned herein. It does not have any regard to your specific investment objectives, financial situation and any of your particular needs. You should read the Prospectus and the accompanying Product Highlights Sheet (“PHS”) for key features, key risks and other important information of the Products and obtain advice from a financial adviser (“FA“) pursuant to a separate engagement before making a commitment to invest in the Products. In the event that you choose not to obtain advice from a FA, you should assess whether the Products are suitable for you before proceeding to invest. A copy of the Prospectus and PHS are available from PCM, any of its Participating Dealers (“PDs“) for the ETF, or any of its authorised distributors for the unit trust managed by PCM.  

    An ETF is not like a typical unit trust as the units of the ETF (the “Units“) are to be listed and traded like any share on the Singapore Exchange Securities Trading Limited (“SGX-ST”). Listing on the SGX-ST does not guarantee a liquid market for the Units which may be traded at prices above or below its NAV or may be suspended or delisted. Investors may buy or sell the Units on SGX-ST when it is listed. Investors cannot create or redeem Units directly with PCM and have no rights to request PCM to redeem or purchase their Units. Creation and redemption of Units are through PDs if investors are clients of the PDs, who have no obligation to agree to create or redeem Units on behalf of any investor and may impose terms and conditions in connection with such creation or redemption orders. Please refer to the Prospectus of the ETF for more details.  

    Investments are subject to investment risks including the possible loss of the principal amount invested. The purchase of a unit in a fund is not the same as placing your money on deposit with a bank or deposit-taking company. There is no guarantee as to the amount of capital invested or return received. The value of the units and the income accruing to the units may fall or rise. Past performance is not necessarily indicative of the future or likely performance of the Products. There can be no assurance that investment objectives will be achieved.  

    Where applicable, fund(s) may invest in financial derivatives and/or participate in securities lending and repurchase transactions for the purpose of hedging and/or efficient portfolio management, subject to the relevant regulatory requirements. PCM reserves the discretion to determine if currency exposure should be hedged actively, passively or not at all, in the best interest of the Products.  

    The regular dividend distributions, out of either income and/or capital, are not guaranteed and subject to PCM’s discretion. Past payout yields and payments do not represent future payout yields and payments. Such dividend distributions will reduce the available capital for reinvestment and may result in an immediate decrease in the net asset value (“NAV”) of the Products. Please refer to <www.phillipfunds.com> for more information in relation to the dividend distributions.  

    The information provided herein may be obtained or compiled from public and/or third party sources that PCM has no reason to believe are unreliable. Any opinion or view herein is an expression of belief of the individual author or the indicated source (as applicable) only. PCM makes no representation or warranty that such information is accurate, complete, verified or should be relied upon as such. The information does not constitute, and should not be used as a substitute for tax, legal or investment advice.  

    The information herein are not for any person in any jurisdiction or country where such distribution or availability for use would contravene any applicable law or regulation or would subject PCM to any registration or licensing requirement in such jurisdiction or country. The Products is not offered to U.S. Persons. PhillipCapital Group of Companies, including PCM, their affiliates and/or their officers, directors and/or employees may own or have positions in the Products. Any member of the PhillipCapital Group of Companies may have acted upon or used the information, analyses and opinions herein before they have been published. 

    This advertisement has not been reviewed by the Monetary Authority of Singapore.  

     

    Phillip Capital Management (S) Ltd (Co. Reg. No. 199905233W)  
    250 North Bridge Road #06-00, Raffles City Tower ,Singapore 179101 
    Tel: (65) 6230 8133 Fax: (65) 65383066 www.phillipfunds.com