Herding behavior or confirmation bias influences the investment decisions of many traders, mainly when investing in the digital market. We allow our emotions to guide our investment decisions, putting logic on the back burner.
However, before investing, especially in a volatile market like crypto, you must understand the risk you are taking. Your investment will only make sense if the possible profit outweighs the risks.
This guide will discuss such a vital crypto metric called the Sharpe Ratio, which can aid you in decision-making. Let’s dive into what is Sharpe Ratio with example, and how to calculate Sharpe Ratio.
What Is Sharpe Ratio
William F. Sharpe created the Sharpe ratio in 1966, and the ratio is also known as the Sharpe measure, Sharpe index, or reward-to-variability ratio. It is a ratio that investors and economists use to assess the potential return of investment (ROI) by evaluating it in relation to the risks.
In simple terms, the Sharpe ratio can be used to evaluate if an investment is worth the risks. Technically, it measures the average return of an investment that goes beyond the risk-free rate per unit of deviation of a particular asset. Therefore, if two different financial instruments are compared in regards to their Sharpe ratio, the asset with a higher Sharpe ratio would be considered better, meaning it has a higher potential of profits in relation to the risks.
Example Of Sharpe Ratio In Use
Consider two portfolios: Portfolio A is expected to return 14% over the next 12 months, while Portfolio B is expected to deliver a return of 11% over the same period. Without considering risk, Portfolio A is clearly the superior choice based on returns alone.
But what about risk? Here’s where the Sharp ratio provides you with a more holistic view of your investments. In this example, Portfolio A has a standard deviation of 8% (more risk) and Portfolio B has a standard deviation of 4% (less risk). The risk-free rate is 3%, the yield on a medium-term U.S. Treasury security.
Now, let’s calculate the Sharpe Ratio for each.
Portfolio A: (14 – 3) / 8 = Sharpe ratio of 1.38
Portfolio B:(11 – 3) / 4 = Sharpe ratio of 2
Given the greater amount of volatility that’s baked into Portfolio A, its Sharpe ratio is lower than Portfolio B’s ratio. This tells us that with a Sharpe ratio of 2, Portfolio B provides a superior return on a risk-adjusted basis.
Generally speaking, a Sharpe ratio between 1 and 2 is considered good. A ratio between 2 and 3 is very good, and any result higher than 3 is excellent.
How To Calculate Sharpe Ratio
To calculate the Sharpe Ratio, use this formula:
Sharpe Ratio = (Rp – Rf) / Standard deviation
Rp is the expected return (or actual return for historical calculations) on the asset or the portfolio being measured.
Rf is the risk-free rate, which is often a U.S. Treasury bill of short maturity. However, some analysts suggest that the Treasury used should be of similar duration to the investment(s).
Standard deviation is a measure of risk based on volatility. The lower the standard deviation, the less risk and the higher the Sharpe ratio, all else being equal. Conversely, the higher the standard deviation, the more risk and the lower the Sharpe ratio.
The market risk premium is represented by the (Rp – Rf) part of the formula. This is the excess return above the risk-free rate.
The ratio should give you a clear view of the relationship between risk and return, illustrating how much excess return is received for the additional risk. The higher the ratio, the greater the investment return relative to the risk taken on with an asset or a portfolio.
Limitations Of The Sharpe Ratio
It’s important to note that the Sharpe ratio assumes that an investment’s average returns are normally distributed on a curve. In a normal distribution, most of the returns are grouped symmetrically around the mean and fewer returns are found in the tails of the curve.
Unfortunately, normal distributions don’t represent the real world of financial markets very well. Over the short term, investment returns don’t follow a normal distribution. Market volatility can be higher or lower, while the distribution of returns on a curve cluster around the tails. This can render standard deviation less effective as a measure of risk.
When the standard deviation fails to accurately represent the risk assumed, the result can be a Sharpe ratio that is higher or lower than it should be.
Then there’s leverage, or debt an investor takes on to increase the potential return from an investment. The use of leverage increases the downside risks in an investment. If the standard deviation rises too significantly, the Sharpe ratio will decline dramatically and the size of any loss will be significantly magnified, potentially triggering a margin call for the investor.
Closing Thoughts
Understanding what it is and how to calculate Sharpe Ratio is beneficial to any retail investor as the ratio is widely used among investors to evaluate investment performance. Part of its popularity is based on the ease of calculating and interpreting the ratio.
Many mutual funds, for example, publish the portfolio’s Sharpe Ratio as part of quarterly and annual performance updates distributed to clients.
Even if the details of calculating expected returns and standard deviation are disagreeably complex, any investor can understand that the higher the Sharpe Ratio, the more attractive the return is relative to the risk taken, thus the more attractive the investment.
