What is the Sharpe Ratio and Risk-Adjusted Return?
Posted: Thu Dec 12, 2024 3:20 am
Some investors confuse the concepts of Sharpe Ratio and risk-adjusted return. It is true that both use the parameters of profitability and volatility, but in different ways.
What is risk-adjusted return?
Most investors are primarily guided by profitability when assessing the value of an investment. But another key parameter is the risk or volatility of a portfolio.
Risk-adjusted return is simply the ratio between the two. That is, dividing the return by volatility:
R/S
Where:
R: Portfolio profitability
S: Portfolio volatility (or portfolio standard deviation).
For example: If we have two portfolios; (A) one with a return gambling data india of 10% and a standard deviation of 12% vs. another portfolio (B) with a return of 11% and a volatility of 20% we will have the following risk-corrected return ratios.
That is, portfolio A has a better risk-adjusted return (0.83) than portfolio B (0.55). In other words, even though B has a slightly higher return (11% instead of 10%), since it supports more risk, it would be less efficient in this respect.
This division gives us the units of return per units of risk . Portfolio A obtains 0.83 units of return vs risk, while B would obtain less, 0.55 units.
This simple division is nothing more than a simplification of the Sharpe Ratio that we will see below and that in the current market context (where rates are 0 or negative) may be more than enough to compare investment portfolios.
What is the Sharpe Ratio?
The Sharpe Ratio is a measure of volatility-adjusted (risk) performance of an investment portfolio. A portfolio with a higher Sharpe Ratio is considered superior relative to its peers. The measure was named after William F. Sharpe, a Nobel laureate and professor of finance at Stanford University.
Unlike the previous ratio, the Sharpe Ratio measures the excess return of the portfolio after subtracting the risk-free interest rate , which represents the return on an investment with no relative risk. Typically, the risk-free rate is taken as the interest rate on 90-day Treasury bills. The excess return is then divided by the volatility of the investment, also known as the standard deviation.
The higher the Sharpe Ratio, the better the fund's return in relation to the amount of risk taken in the investment.
The formula for calculating the Sharpe ratio is {R(p) – R(f)} / s(p)
Where:
R (p) : Portfolio profitability
R (f) : Risk-free interest rate
S (p) : Volatility (Standard deviation of the portfolio).
For example: If we have two portfolios; (A) one with a return of 10% and a standard deviation of 12% vs. another portfolio (B) with a return of 11% and a volatility of 20% we will have the following Sharpe Ratios. The risk-free interest rate for both portfolios will be 3%:
(A): (10% – 3%) / 12% = 0.58 Sharpe Ratio
(B) (11% – 3%) / 20% = 0.4 Sharpe Ratio
If two funds offer similar returns, the portfolio with higher volatility will have a lower Sharpe Ratio. To compensate for the higher standard deviation, the fund must generate a higher return to maintain a higher Sharpe Ratio. In simple terms, it shows how much additional return an investor gets by taking on additional risk . Therefore, the Sharpe Ratio is a very effective measure of return by adjusting the return with the volatility (risk) taken.
As a guideline, the Sharpe Ratio of portfolios is normally below 0.5. This indicates that an investor should accept, as a rule, twice the risk as the return .
This is why inbestMe stresses the importance of financial planning and always recommends knowing your financial goals and horizon well. Finally, you should know which profile is most suitable for you.
What is risk-adjusted return?
Most investors are primarily guided by profitability when assessing the value of an investment. But another key parameter is the risk or volatility of a portfolio.
Risk-adjusted return is simply the ratio between the two. That is, dividing the return by volatility:
R/S
Where:
R: Portfolio profitability
S: Portfolio volatility (or portfolio standard deviation).
For example: If we have two portfolios; (A) one with a return gambling data india of 10% and a standard deviation of 12% vs. another portfolio (B) with a return of 11% and a volatility of 20% we will have the following risk-corrected return ratios.
That is, portfolio A has a better risk-adjusted return (0.83) than portfolio B (0.55). In other words, even though B has a slightly higher return (11% instead of 10%), since it supports more risk, it would be less efficient in this respect.
This division gives us the units of return per units of risk . Portfolio A obtains 0.83 units of return vs risk, while B would obtain less, 0.55 units.
This simple division is nothing more than a simplification of the Sharpe Ratio that we will see below and that in the current market context (where rates are 0 or negative) may be more than enough to compare investment portfolios.
What is the Sharpe Ratio?
The Sharpe Ratio is a measure of volatility-adjusted (risk) performance of an investment portfolio. A portfolio with a higher Sharpe Ratio is considered superior relative to its peers. The measure was named after William F. Sharpe, a Nobel laureate and professor of finance at Stanford University.
Unlike the previous ratio, the Sharpe Ratio measures the excess return of the portfolio after subtracting the risk-free interest rate , which represents the return on an investment with no relative risk. Typically, the risk-free rate is taken as the interest rate on 90-day Treasury bills. The excess return is then divided by the volatility of the investment, also known as the standard deviation.
The higher the Sharpe Ratio, the better the fund's return in relation to the amount of risk taken in the investment.
The formula for calculating the Sharpe ratio is {R(p) – R(f)} / s(p)
Where:
R (p) : Portfolio profitability
R (f) : Risk-free interest rate
S (p) : Volatility (Standard deviation of the portfolio).
For example: If we have two portfolios; (A) one with a return of 10% and a standard deviation of 12% vs. another portfolio (B) with a return of 11% and a volatility of 20% we will have the following Sharpe Ratios. The risk-free interest rate for both portfolios will be 3%:
(A): (10% – 3%) / 12% = 0.58 Sharpe Ratio
(B) (11% – 3%) / 20% = 0.4 Sharpe Ratio
If two funds offer similar returns, the portfolio with higher volatility will have a lower Sharpe Ratio. To compensate for the higher standard deviation, the fund must generate a higher return to maintain a higher Sharpe Ratio. In simple terms, it shows how much additional return an investor gets by taking on additional risk . Therefore, the Sharpe Ratio is a very effective measure of return by adjusting the return with the volatility (risk) taken.
As a guideline, the Sharpe Ratio of portfolios is normally below 0.5. This indicates that an investor should accept, as a rule, twice the risk as the return .
This is why inbestMe stresses the importance of financial planning and always recommends knowing your financial goals and horizon well. Finally, you should know which profile is most suitable for you.