Sharpe Ratio

The most commonly found term that you would find when you dive into the world of Finance. Sure then, let’s see the what’s and why’s of this shall we?

I will divide this blog into few parts and you may navigate accordingly as per your needs.

1. History
2. Use Case
3. Word of Caution.

History

During the 1950’s the world of finance was looking for a way to determine the quality of any financial investment. For any two samples of financial investments even with same expected return both could have drastically different levels of risk involved. During these times was when the smart wiz around the block William Sharpe came up with a term risk/reward ratio! Wait ? Aren’t we discussing Sharpe ratio… Well he initially coined Sharpe ratio and why not it’s actually a risk v/s reward thingy ain’t it ? The original name in his paper was reward-to-variability and with time he himself realised it is more famous as Sharpe Ratio(well he’s got his name after-all and we have a got a crucial ratio to analyse our portfolio performance so a win-win😉).

Use Case

Here I will state few points from investopedia (even if you read this blog I will totally suggest you go through investopedia since there isn’t any website which gives a clear cut explanation regarding financial terminology. I call it the Oxford Mini Dictionary for Finance)

How to Use the Sharpe Ratio to Analyze Portfolio Risk and Return

• The Sharpe ratio can be used to evaluate a portfolio’s past performance (ex-post) where actual returns are used in the formula.
• The Sharpe ratio can also help explain whether a portfolio’s excess returns are due to smart investment decisions or a result of too much risk.
• The Sharpe ratio is often used to compare the change in overall risk-return characteristics when a new asset or asset class is added to a portfolio.

Word of Caution

The formula for Sharpe Ratio is as follows:

Sharpe Ratio =

(Expected Return — Risk Free Rate)/Standard Deviation of Return

Here the Risk and Standard Deviation are synonymous only when the returns are normally distributed. But in the world of finance you could find the data quite skewed such as in corporate bonds have a asymetric or fat tailed profile of returns . This causes the Sharpe Ratio to mis-calculate the risk involved with that particular financial vehicle.

Also limited historical data can result in Sharpe ratio which is significantly biased.