By James Bell
The Sharpe ratio is a risk vs return metric. The economist William F. Sharpe built this formula in 1966. He would later receive a Nobel Prize for his work on CAPM. The higher the number the better here for this ratio. Remember to keep the periods consistent when making comparisons. A typical period is monthly but we’ve seen arguments on how to do it daily.
You can compare Sharpe ratios to look at performance. For example, if a portfolio has a Sharpe ratio of 0.35 but the average ratio for similar funds is 0.24, then the portfolio has performed better then the average of similar funds after being adjusted for risk.
Standard deviation of the Portfolio Return
This is the return that the portfolio provides and is a weighted sum of all the pieces that make up the portfolio returns for a period. We go more in depth in our article about Portfolio Returns.
This is the return that you can expect with a “risk-less” investment. In the U.S., the rate is often anchored to Treasury Bills or “T-bill”. To get this number, we suggest that you go straight to the source. Treasury.gov has yield curve rates. Typically we use 10-year, but other sources state the 3 month T-bill being acceptable. Some argue that a 10-year or 30-year bond cannot adjust to inflation the way a 3 month can. It really depends on the time horizon in question. It helps support your results if you include this in your assumptions and explain why,
Standard Deviation is a statistical term. It is the square root of the variance. This is a way of determining absolute values of the variance. It gives us a clearer picture of the up and down swings the portfolio takes without having those peaks and valleys cancel each other out.
The biggest criticism with this ratio is that it assumes a normal distribution of data points. This standard deviation can be further manipulated by increasing the length period in which you determine your standard deviation. The longer the period, the typically less volatile a portfolio may look. Over a greater period of time, the short-term peaks and valleys aren’t as eventful.
The Sharpe Ratio also shows positive volatility as a negative. Some consider the alternative Sortino Ratio to be an improvement because it only considers the downside of volatility.
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