The Sharpe ratio (also known as the Sharpe index, the Sharpe measure) – is a tool that helps investors to measure the amount of risk they are taking versus the performance of their investment. It was developed by and named after William F. Sharpe in 1966.
Understanding the Sharpe ratio
The Sharpe ratio was developed by a professor of finance and Nobel Laureate William F. Sharpe. His goal was to give investors a broader perspective on the amount of risk they are taking to achieve a desirable ROI (return on investment). The Sharpe ratio estimates the performance of their investments after deducting the risk-free rate of return and then dividing by the standard deviation of the surplus revenue. The risk-free rate is the theoretical rate of return with a relatively safe investment where the risk is close to zero. The standard deviation constitutes a risk indicator that measures price oscillation from the average price.
The Sharpe ratio appears to be a useful tool for those investors who need to juxtapose risk-adjusted returns of particular portfolios and assets. In its turn, the portfolio with a higher Sharpe ratio theoretically would have a better performance once it’s been adjusted for the risk.
Everybody tends to gain as much as possible from their investments. And we are all aware of the necessity of the importance of the risk assessment. The Sharpe ratio could provide you with certain support and help you to evaluate all the risks you’re taking with your assets and investment portfolio. Who wouldn’t like to achieve the same returns but also take significantly less amount of risk?
Is there a “good” Sharpe ratio?
As we know already, the Sharpe ratio is a remarkable instrument for comparing the returns of different investments. Also, it helps us to understand whether adding an asset to a portfolio would affect the risk-adjusted returns. When the Sharpe ratio is high, your risk-adjusted returns are better. It’s widely accepted that a ratio below 1.0 isn’t satisfactory, i.e., the risks you’re taking are certainly excessive. The acceptable risk would be in a range of 1 to 1.99; 2.0 – 2.99 would be good enough, and 3.0 + would be considered as the excellent one.
The difference between the Sharpe ratio and the Sortino ratio.
Both of the ratios could help us to estimate the risk-adjusted returns. However, they have different approaches. The main difference lies in the fact of how one should address the standard deviation and also volatility.
The Sharpe ratio uses the total volatility and takes the standard deviation of both the positive and the negative surplus returns. It’s important to note that the upside volatility and the increasing price movements could distort the results and then give a lower Sharpe ratio.
While the Sortino ratio relies on only negative volatility and uses only negative excess returns, by removing the upside volatility, the Sortino ratio doesn’t treat the positive volatility as a “risk’ or a “threat.” However, lots of investors tend to prefer the Sharpe ratio for assets that have low volatility with the low price oscillation. And in the case of a lot of volatility, there’s a strong tendency to rely on the Sortino ratio, with its isolation of the declining deviation.
What about the limitations?
The fact that the Sharpe ratio is taking into account both the positive and the negative volatility could be seen as a significant limitation. Even with the positive price swings, the ratio could be lower. That happens due to the lack of distinguishing the positive and the negative price fluctuations.
Another limitation we should take into account is that the ratio could be adjusted and manipulated in a way. You could either play with the time period; the ratio would be different in case you measure only daily returns or if you measure longer time periods. The daily ones would always be higher than the weekly or monthly ones.
One more reason why the Sharpe ratio could be tricky is that you can always choose the period you’re assessing. And by that, you could present the best potential risk-adjusted returns. For instance, one could choose a period with low volatility and to smooth the ratio calculations.