Sharpe Ratio

1) The Sharpe ratio is a risk adjusted measure of return. Basically, it is answering this fundamental question; “Is your investment’s returns compensating you for the risk you have taken? Or is the risk that you have taken eating too much into you returns, such that you are not generating a positive cash flow from the investment?”

2)The formula of the Sharpe ratio is as follows.

Let us inspect the numerator and the denominator and then bring it all together.

3)In the numerator, we are effectively measuring the excess return generated by the asset over the risk-free rate. This is a very common metric of performance in the financial world. The risk-free rate is generally taken as the yield offered on the 10-year US treasury bond.

4) The denominator is measuring the risk of the asset by studying the standard deviation. A greater standard deviation means the returns are fluctuating greatly which further means that the asset has an unpredictable nature of return, making it risky.

5) Hence, by dividing the two, we are neutralizing the return with the risk. The higher the Sharpe Ratio, the better because it means that the asset is giving you returns which are higher than its risk profile. The Sharpe Ratio for a risk-free investment is 0.

6) As you know by now, I always make sure that you get the complete picture, so here are a couple of criticisms of the Sharpe Ratio. a) The denominator of the ratio (the Standard Deviation) can be skewed and manipulated easily to give a desired high Sharpe Ratio. For example, the annualized standard deviation of daily returns is generally higher than that of weekly returns which is, in turn, higher than that of monthly returns.

b) Connected to the first, the holding period also affects the Standard Deviation. Volatile returns can always be smoothed, simply by expanding the holding period that you are looking at for the investment. Choosing a period for the analysis with the best potential Sharpe ratio, rather than a neutral look-back period, is another way to cherry-pick the data that will distort the risk-adjusted returns.