Sharpe Ratio

What is the Sharpe Ratio?


The Sharpe ratio provides insight into the risk/reward scenario of a security or a portfolio.  The Sharpe ratio measures excess investment returns as a function of volatility.  The premise of this ratio is that the investment or portfolio must return gains which are proportional to the risk that is being taken.  TIt is generally accepted that a higher sharpe ratio is a better investment; however, we will discuss below the exception to this rule.

Problems with Sharpe Ratio


The formula is more aptly applied to more liquid investments which have returns which are normally distributed.  The issue with this formula lies in its application to investments or securities that do not have normally distrubuted returns.  Portfolios utilizing automated trading systems are a great example of this, they exhibit irregular returns through kurtosis and skewness.

There are many trading systems which boast 98% profitability; they do this by having no stop loss orders and taking profit when a very small gain is achieved.  However, 2% of the time, they are taking very large losses.  In this scenario, a portfolio may achieve a very high Sharpe ratio until it inevitably get hit. 

Sharpe Ratio Formula:


Below, we have the formula use to calculate the Shape Ratio.  Let's review each component. 

Sharpe Ratio

The formula can be used to measure portfolio performance on any time frame assuming a normal distribution of returns.

The risk free rate of return is the benchmark used to determine excess portfolio return.  It is usually benchmarked against a treasury security whose duration matches term of the investment that it is being used to benchmark.  For shorter term porfolios, the risk free rate could be derived using the T-Bill rate.  Medium term portfolios can use treasury notes while longer term porfolios can use t-bond rates. 

The difference between the porfolio return on the risk free rate of return is known as "excess return".  We now divide this number by the standard deviation of the asset in question to arrive at the sharpe ratio.
Tim Ord
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