What is a good Sharpe ratio?
Imagine you have two investment options. Option A yields 8% in annual return with a 10% standard deviation. Option B offers a 6% yearly return and a 5% volatility. Which of these investment choices has a higher risk-adjusted return?
Answer: You can’t respond to that question using only average values. Why? The alternatives also differ in terms of the variance of the returns from the mean. The Sharpe ratio tells investors how much investment returns with the associated risk they may expect.
According to research, the Sharpe ratio of American shares has averaged about 0.35 over the last 50 years. The American bonds’ standard Sharpe ratio has been about 0.50 for the same period.
This situation raises the query: What is a good Sharpe ratio?
The key is understanding that a greater Sharpe ratio signifies superior performance when considering risk. In our example, the second investment choice is more appealing. Why? It has a higher Sharpe ratio, signifying a higher return when adjusted for risk.
This blog post explains the Sharpe ratio in simple terms. We will examine real-life cases and key factors for investors looking to make knowledgeable choices.
First…
Definition: The Sharpe ratio is a measure of risk-adjusted return. It helps investors understand how much return they receive for the risk they take.
In 1966, economist William F. Sharpe introduced the Sharpe ratio based on his research on the CAPM model. He referred to it as the reward-to-variability ratio. Sharpe was awarded the Nobel Prize in economics for his contributions to the CAPM in 1990.
The formula of the Sharpe ratio is simple:
Subtract the risk-free rate from the investment return. Then, divide the result by the standard deviation of the investment’s return. The risk-free rate is typically a Treasury bond rate.
A higher Sharpe ratio indicates better risk-adjusted performance. This means that the investment provides higher returns for each unit of risk. Conversely, a lower Sharpe ratio suggests less favorable risk-adjusted returns.
This ratio is crucial for comparing investments. It helps investors choose assets with the best return for the least risk. It is commonly used for mutual funds, portfolios, and individual securities.
The Sharpe ratio is a key tool for assessing investment performance. It balances return against risk, guiding better investment decisions.
Definition: The Sharpe ratio assesses the return adjusted for risk. It measures the additional gain of an investment (or portfolio) relative to the risk (standard deviation). A high Sharpe ratio signifies improved performance when adjusting for risk, showcasing increased returns for the same risk level. Or decreased risk for the same level of returns.
Below, you can learn what the Sharpe ratio measures.
The Sharpe ratio provides valuable insights into how well an investment compensates investors for the risk taken. Here are the five main aspects it measures:
Calculating the Sharpe ratio is essential for assessing the risk-adjusted return of an investment. This ratio helps investors determine whether the returns of an investment compensate adequately for the risk taken. Here’s a step-by-step guide on how to calculate the Sharpe ratio:
Excess Return=−
This step isolates the additional return earned over a risk-free investment.
Typically, a Sharpe ratio above 1 is considered acceptable, above 2 is considered good, and above 3 is considered
excellent.
The Sharpe ratio is widely used for evaluating risk-adjusted returns. However, it has several limitations that investors should be aware of. Understanding these limitations helps in making more informed investment decisions.
Data analysis often feels like exploring a jungle of numbers and statistics – easy to get lost in.
Enter the Sharpe ratio, a vital tool for investment assessment. But deciphering it requires more than just staring at spreadsheets; it demands the magic of data visualization.
While Excel is a trusty companion, it lacks the advanced visualizations necessary for Sharpe ratio analysis. Fear not, for ChartExpo emerges as the ultimate guide. Its powerful data visualization capabilities lead you through the dense wilderness of data.
Let’s learn how to install ChartExpo in Excel.
ChartExpo charts are available both in Google Sheets and Microsoft Excel. Please use the following CTAs to install the tool of your choice and create beautiful visualizations with a few clicks in your favorite tool.
Let’s analyze the Sharpe ratio example data below using ChartExpo
Asset Class | Sharpe Ratio |
Stocks | 0.8 |
Stocks | 0.9 |
Stocks | 1.1 |
Stocks | 1.2 |
Stocks | 0.7 |
Bonds | 0.5 |
Bonds | 0.6 |
Bonds | 0.7 |
Bonds | 0.4 |
Bonds | 0.3 |
Real Estate | 0.6 |
Real Estate | 0.7 |
Real Estate | 0.8 |
Real Estate | 0.9 |
Real Estate | 1 |
Commodities | 0.4 |
Commodities | 0.5 |
Commodities | 0.6 |
Commodities | 0.7 |
Commodities | 0.8 |
Cryptocurrency | 0.7 |
Cryptocurrency | 0.75 |
Cryptocurrency | 0.78 |
Cryptocurrency | 0.88 |
Cryptocurrency | 0.82 |
An appropriate Sharpe ratio typically ranges from 1 to 3. A ratio above 1 is considered acceptable, above 2 is good, and above 3 is excellent. These benchmarks indicate favorable risk-adjusted returns.
For day trading, a good Sharpe ratio is generally above 2. This indicates strong risk-adjusted returns. Ratios above 3 are excellent and suggest very favorable performance. High Sharpe ratios help ensure the trading strategy effectively balances risk and return.
A low Sharpe ratio is typically below 1. This indicates that the investment’s returns do not adequately compensate for the risk taken. Ratios below 0.5 are considered poor, suggesting unfavorable risk-adjusted performance.
Knowing what is a good Sharpe ratio is vital when assessing investment success. The Sharpe ratio assesses the relationship between returns and risk, looking at how effectively an investment rewards risk. A higher Sharpe ratio signifies superior performance when considering risk.
A Sharpe ratio above 1 is generally acceptable. It suggests the investment provides reasonable returns for the risk incurred. Investors often look for ratios above 1 when assessing potential investments – it indicates that returns outweigh the risk.
Ratios above 2 are seen as good. These suggest that the investment offers strong returns relative to its risk. A Sharpe ratio in this range signals a solid investment opportunity for many investors. This means that the strategy effectively manages risk while achieving desirable returns.
Ratios above 3 are considered excellent. Such high ratios indicate exceptional risk-adjusted performance. Investments with Sharpe ratios above 3 are rare and typically reflect highly efficient strategies. These investments provide significant returns for relatively low risk, making them highly attractive.
In conclusion, a good Sharpe ratio varies by context, but generally:
Understanding these benchmarks helps to evaluate and compare investments effectively.
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