Sharpe Ratio: Formula, Calculation and Importance
Risk is a critical factor for investors to consider before making any investment decision. Apart from selecting an investment option that fits the risk profile, another important thing to consider is the reward you’re getting for the risk you are undertaking. The risk-reward ratio is a crucial factor to get the most out of your investments. The Sharpe Ratio is a mathematical formula that can help you in this regard.
What is Sharpe Ratio in Mutual Funds and How It is Measured?
Developed by William F. Sharpe, the Sharpe Ratio measures the risk-adjusted returns of a portfolio. In simpler terms, the ratio signifies the return of a portfolio or a fund delivered per unit of risk undertaken.
The Sharpe Ratio takes into account the expected or realized returns over the returns generated by a risk-free asset like a bank fixed deposit. This Sharpe Ratio can help understand an investment’s risk-to-reward ratio compared to the returns generated by a risk-free asset. It also considers the underlying volatility with the help of the standard deviation of the portfolio’s excess returns. This can help in justifying taking a risk regarding volatility. A higher Sharpe Ratio is said to be more beneficial to investors, especially when comparing portfolios or funds that are similar.
Sharpe Ratio Formula
In order to understand this ratio better, it is helpful to know how it is calculated. The Sharpe Ratio formula is as follows:
Sharpe Ratio = R(p) – R(f)
R(p) = Return of portfolio. This is needed in order to know the returns that a fund has generated over a period of time.
R(f) = Risk-free return rate. This refers to returns delivered by risk-free security like a bank fixed deposit.
SD = Standard Deviation of the returns delivered by the fund
Why Sharpe Ratio is Important?
As discussed earlier, the Sharpe Ratio holds a lot of significance while making investing decisions. Here are some of the key reasons why the Share Ratio is important.
Tool for comparison
The Sharpe Ratio is helpful as it can be used as a tool for comparing different portfolios or funds. An investor can calculate the Sharpe Ratio of different funds to select a fund that offers the most for their buck.
Helps in calculating risk-adjusted returns
With the help of Sharpe Ratio calculator, an investor can easily know the risk-adjusted returns of a particular fund or portfolio. This is helpful as it can aid an investor in knowing the risk-to-reward ratio and making investment decisions accordingly.
Analysis of a fund’s performance
Another important feature of the Sharpe Ratio is that it helps an investor analyze a fund’s performance by calculating returns it has generated for the risk being undertaken. It can be used to analyze funds that make use of both, growth and value styles of investing.
Helps with portfolio diversification
The Sharpe Ratio also aids in making decisions related to diversifying their portfolio. Depending on the Sharpe Ratio, adding funds to a portfolio can help in reducing the risk.
Sharpe Ratio in Mutual Fund
The Sharpe Ratio is an important thing to consider while analyzing or selecting a mutual fund. It helps investors know the inherent risk of an investment that is undertaken to generate returns. The ratio also considers the standard deviation of returns which is the volatility. A mutual fund can be compared against the benchmark or with similar mutual funds in order to make an investing decision.
Although the Sharpe Ratio is a great tool in order to select a fund with a good risk-to-reward ratio, it should not be the sole deciding factor. There are several factors which need to be considered while investing in a mutual fund, like the fund’s type, historical performance, investment managers, total assets under management (AUM), etc.
To conclude, an investor has many tools available to make sound investing decisions. The Sharpe Ratio is a helpful tool which can make it easier to manage risks and analyze portfolios.
FAQs of Sharpe Ratio
What is the importance of Sharpe Ratio?
The Sharpe Ratio is important as it can help in knowing the risk-adjusted returns of an investment.
Is Sharpe Ratio a good measure?
Sharpe Ratio is a good measure to know the returns delivered in comparison to the risk that is being undertaken.
What is the Sharpe Ratio?
Sharpe ratio is a ratio which compares the returns delivered by a fund in comparison to the returns delivered by a risk-free asset like a fixed deposit. It helps to know the returns delivered per unit of risk undertaken.
What is a good Sharpe Ratio?
Usually, the higher the Sharpe ratio, the better it is. A Sharpe Ratio above 1 is considered to be good and a ratio above 3 is considered to be excellent.
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