Financial ratios are an important part of the financial statements of an organization. The ratios provide information about the functioning and stability of the business. It allows investors to make the right decision. If the financial ratios are not included in the financial statements of the company, it is possible to calculate them.
Developed by William F. Sharpe, the Sharpe ratio helps investors calculate the return on an investment as compared to the risk. All investments have a certain amount of risk associated with it. Hence, the ratio will help compare the return with the risk in a systematic manner.
Importance of Sharpe ratio
The ratio is of crucial importance for investors because it shows the average return generated in excess of the risk-free rate per unit of the total risk. The total risk on investment includes the price fluctuations in an asset. Before making an investment or adding a fund to the portfolio, investors are keen to know about the expected returns. The Sharpe ratio provides information about the same and helps make the right decision. It can be used for a fund or an entire portfolio.
When you subtract the risk-free rate from the return, it shows your profit in a clear and concise manner. The risk-free rate of return is the return generated on an investment that has no risk, for example, U.S. Treasury bonds.
Higher the Sharpe ratio, the more profitable the return on investment. This ratio will help an investor understand the relationship between the risk and return of a stock.
Calculation of Sharpe Ratio
Sharpe Ratio= Rp−Rfσp
RP is the return on a portfolio, Rf is the risk-free rate and σp is the standard deviation of the excess return of the portfolio.
What the ratio means
The Sharpe ratio is a commonly used method to calculate the risk-adjusted return. When you add assets in a portfolio with low correlations, you can decrease the risk without compromising on the return. Diversification of a portfolio will improve the Sharpe ratio as compared to other portfolios with no or minimal diversification.
You can use the ratio to evaluate the past performance of a portfolio where the actual returns are used in the formula. You can also use the expected portfolio performance to calculate the ratio before investing.
The ratio helps understand whether the excess returns on the portfolio are because of better decision making or as a result of excessive risk. It is possible that one fund or portfolio enjoys higher returns as compared to the peers and if the return does not come with additional risk, it is a good investment.
The higher the Sharpe ratio of a portfolio, the better is the risk-adjusted-performance. When analysis shows a negative ratio, it means that the risk-free rate is more than the return on the portfolio, and the return may be negative. A negative ratio is not ideal for an investor.
Example of Sharpe ratio
Whenever a new asset is added to the portfolio, the ratio is calculated to compare the changes in the risk-return characteristics. Let us assume that Mr. X’s portfolio had a return of 15% over the last year. The volatility of the return is 12% and the risk-free rate for the portfolio is 3.5%. This means the Sharpe ratio will be 95.8%. (15%- 3.5%) / 12%.
Limitations of the ratio
The ratio makes use of the standard deviation of returns in the denominator as the proxy of the total risk of the portfolio. This means it assumes that the returns are distributed normally. In financial markets, the returns are skewed away from the average due to a large number of ups and downs in prices. The standard deviation also assumes that the price movements in any direction are equally risky.
It is easy to manipulate the ratio by fund managers who wish to boost the history of risk-adjusted return. By increasing the measurement interval, it is easy to manipulate the ratio. It will lead to low volatility and will reflect higher monthly returns.
It is best to choose a period for the analysis and not a neutral look back period in order to find the best Sharpe ratio on a portfolio.
- The Sharpe ratio shows the portfolio’s past performance or the expected future performance for the risk taken by the investor.
- There are several weaknesses of the ratio including the assumption that the returns are distributed normally.
- A high ratio is good in terms of returns for an investor.
- The ratio allows an investor to judge whether the risk is worth the return.