Investors want to take less risk with high returns, but it does not happen. To gain high return, one has to take high risk. How can an investor choose between an investment with high return and a relatively high risk, and an alternative investment with low return and low risk? The sharpe ratio method can help the investor find out how investment utilizes risk. This article analyzes this method in evaluating the performance of funds.
Generally, investors can be taken as risk averse. If
an individual has surplus funds for investment, he
would prefer to invest in risk-free securities if he
is averse to taking any risk. So, if he is going to assume
some risk, then he would like to be compensated by the
higher return from the investment. The higher amount
of risk assumed should always be compensated by the
higher return expected from the investment. Investors
always try to maximize the return per unit of risk that
they assume. Considering the fact that higher expected
returns are desirable but higher risks are not; how
investors can choose between an investment with a higher
expected return and a relatively high risk, and an
alternative investment with a lower expected return and
lower risk is the moot question. The Sharpe Ratio devised
by Prof. William Sharpe, Nobel Prize Laureate in
Economics, helps investors find out how effectively an
investment utilizes risk, and compares various
investments with different risk profile.
The Sharpe Ratio is calculated by dividing the excess
return of an asset by its standard deviation of returns.
The excess return is calculated by the asset’s return in
excess of the risk-free rate (usually 90-day T-Bills) for a
given a period (it may be one year, two years, three years,
etc). In other words, the Sharpe Ratio calculates the
amount of ‘reward per unit of risk’ from an investment.
Sharpe Ratio =
Standard Deviation
Return on the Asset − Treasury Bill Rate
Significance of Sharpe Ratio
Sharpe Ratio is very useful to investors for comparing the
different investment avenues, and is particularly used to
evaluate the performance of mutual fund managers. |
