Sharpe Ratio

Sharpe Ratio

The Sharpe ratio is a measure of risk-adjusted performance of an investment. It compares the return of an investment with its risk by dividing a portfolio's excess returns by a measure of its volatility . Excess returns are those above an industry benchmark or the risk-free rate of return . The formula for Sharpe ratio is: `Sharpe Ratio = (Rp - Rf) / σp` where `Rp` is the return of the portfolio, `Rf` is the risk-free rate, and `σp` is the standard deviation of the portfolio's excess return . A higher Sharpe ratio is better when comparing similar portfolios as it indicates either higher returns or lower volatility . However, it has inherent weaknesses and may be overstated for some investment strategies ¹. The **Sharpe ratio** has several strengths and weaknesses. Some of its strengths include its simplicity and its ability to compare investments across different types of assets ¹.

Strengths and weaknesses of Sharpe Ratio

However, it also has some weaknesses. One of them is its reliance on standard deviation which is based on the normal distribution curve. Some investments may exhibit such a distribution but it cannot encompass certain strategies . Another weakness is that it treats all volatility the same, even though sharp volatility to the upside may not necessarily be a bad thing for an investor looking for a potentially rewarding investment .