Sharpe Ratio measures returns with respect to the risk taken. The returns can be both negative and positive. A higher Sharpe ratio means, a higher return without too much risk. Thus, while Investing, investors should choose a fund that shows a higher Sharpe ratio. Sharpe Ratio comes very handy to measure the risk-adjusted returns potential of a Mutual Fund.
The Sharpe ratio named after Stanford professor and
Nobel laureate William F. Sharpe.
We will give you a better understanding of how this ratio works, starting with its formula:
S (x) = (rx - Rf) / StdDev (x)
X is the investment rx is the average rate of return of X Rf is the best available rate of return of a risk-free security (i.e. T-bills) StdDev(x) is the Standard Deviation of rx
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Using the Sharpe ratio formula, let's assume for illustration purpose that you expect your stock Portfolio to return 15 percent next year. If returns on risk-free Treasury notes are, say, 7 percent, and your portfolio carries a 0.06 standard deviation, then from the formula we can calculate that the Sharpe ratio for your portfolio is:
(0.15 - 0.07)/0.06 = 1.33
This means that for every point of return, you are shouldering 1.33 units of risk.
Portfolios with higher rates of risk might have a metric of 1, 2, or 3. Any metric equal to or greater than 3 is considered a great Sharpe measurement and a good investment all else equal.