What Is the Sharpe Ratio?
Sharpe ratio is a measure of a fund’s performance compared to the risk. This ratio helps to analyse if the fund’s returns are worth the risk taken.
William Sharpe developed the Sharpe ratio in 1966. This ratio was earlier called the reward-to-volatility ratio.
What Is the Sharpe Ratio Formula?
Sharpe ratio is calculated using this formula=
(Rp – Rf)/Standard deviation
Here:
Rp – return expected from the fund
Rf – return from risk-free asset (e.g. government instruments)
Example to Understand the Sharpe Ratio
Let’s understand this with an example. Car X is a fast car, but sometimes it might break down in the middle of your destination. Car Y is slower, but it's reliable and smooth with no breakdown. Sharpe ratio will help you choose the better car. Is Car X with risk better, or is a slow Car Y better?
In the context of a mutual fund, the Sharpe ratio tells you if high returns with more risk are better or worse than low returns with less risk.
How to Interpret the Sharpe Ratio?
FAQs on Sharpe Ratio
1. Can Sharpe Ratio be negative?
Yes, the Sharpe Ratio can be negative. It means that the investment delivered returns below the risk-free rate during the measured period.
2. Does the Sharpe Ratio change?
Yes, the Sharpe Ratio changes over time based on volatility, market conditions, and investment performance. If returns exceed the risk-free rate during a period, the Sharpe Ratio is positive; if returns fall below the risk-free rate, it can turn negative.
3. Why Sharpe Ratio matters?
Sharpe Ratio helps evaluate whether a fund has generated returns higher than the risk-free rate after accounting for risk. It highlights whether the risk taken has been worthwhile during the measured period.
Important links:
1. IPO hub page- Calendar of Upcoming, live and closed IPOs.
2. Mutual fund learning hub- Get answers to your basic mutual fund questions.
