The Sharpe Ratio is one of the three primary ratios used for portfolio management. The ratio expresses how much extra profit you get in exchange for the increased volatility of holding a riskier asset. There is a given rule that investors must be compensated for the increased risk by not keeping a risk-free asset.
Example of Sharpe Ratio
Sharpe Ratio= Rp/Rfσp
Rp= return of the portfolio
Rf= risk-free rate
σp= standard deviation of the portfolio’s excess return
For example, our desired investment is the stock of ABC Corp Plc. The stock has returned an average of 20% annually over the past five years.
The risk-free investment is the UK Treasury Bill which has an interest rate of 0.4%.
The standard deviation (volatility) of ABC Plc is put at 15%.
The Sharpe Ratio calculation = (20% – 0.4%) / 25%= 0.784
Why is it important to know Sharpe Ratio?
Sharpe ratios suggest isolating the earnings associated with risk-taking activities by subtracting the risk-free rate from the mean return. It gives a fair idea of whether it is beneficial for an investor to invest in a given portfolio considering the risk-return preference.