What is the Sharpe Ratio and why is it important?

What is the Sharpe Ratio and why is it important?

The Sharpe Ratio is a measure of risk-adjusted return. It helps investors understand how much excess return they are receiving for the extra volatility they endure for holding a riskier asset.

How do you calculate the Sharpe Ratio?

To calculate the Sharpe Ratio, subtract the risk-free rate from the expected return of the investment, then divide that by the standard deviation of the investment's returns.

What does a higher Sharpe Ratio indicate?

A higher Sharpe Ratio indicates that the investment has a better risk-adjusted return, meaning it provides more return per unit of risk.

Can you give me an example of how to use the Sharpe Ratio?

Sure! If an investment has an expected return of 10%, a risk-free rate of 2%, and a standard deviation of 5%, the Sharpe Ratio would be (10% - 2%) / 5% = 1.6.

Are there any limitations to the Sharpe Ratio?

Yes, the Sharpe Ratio assumes returns are normally distributed and may not accurately reflect the risk of investments with skewed return distributions.