Everybody likes to earn big returns on their investments. But, unfortunately, big returns and big risk go hand in hand. Assets that have the highest return potential are also the riskiest to invest in. Sharpe Ratio can help you maximise your investment returns and lower your investment risk.
The Sharpe Ratio:
Every investment option does not give you the same amount of return for every unit of risk you incur. The Sharpe Ratio helps you calculate this--exactly how much return you get for every rupee or unit of risk.
So, the Sharpe Ratio helps you measure the excess return a risky asset (such as a stock) gives you compared to a risk-free asset. Essentially, you try to figure out if the risk is worth taking.
Government bonds are usually considered to be a risk-free asset. This is because the government guarantees the returns on its bonds. Any other asset is considered a risky asset because its returns are not guaranteed by the government. But, they come with the advantage of extra returns.
Sharpe Ratio ascertains whether the additional returns an asset generates is greater than the excess risk you take on by investing in it.
Calculating Sharpe Ratio:
Sharpe ratio can be calculated for a stock, mutual fund, ETF, and even your overall portfolio.
You can calculate Sharpe Ratio by dividing the excess return you get (compared to a government bond) by the asset's risk .
Excess return is the difference between the return you are expecting from the investment and the yield on a ten-year government bond.
Investment risk is calculated as the standard deviation of the historical returns of the investment.
Assume that you bought a stock that is expected to give a return of 15% in one year. The standard deviation of the stock’s historical returns is 5% and the ten-year government bond is trading at a yield of 9%. The Sharpe Ratio for your stock will then be (15% - 9%) / 5% = 1.2. This means that for every 1% risk that you are taking by investing in the stock, you can earn an additional 1.2% return. Since the additional return is greater than the risk, you should consider buying the stock.
Utility of Sharpe Ratio:
Sharpe Ratio is often used to choose between two investment alternatives. Let’s say you have to decide between the earlier stock and a stock with a Sharpe Ratio of 1.6. The first stock has a Sharpe Ratio of 1.2. In this case, the second stock could be a better investment. It can give you an additional 1.6% return for every 1% risk you take. The first stock may only give you an extra 1.2% return.
You can also use Sharpe Ratio to see how buying a stock will affect your overall portfolio. You may buy a stock whose Sharpe ratio is greater than your portfolio’s Sharpe Ratio. This may increase your portfolio’s return potential while reducing its risk. Adding a stock with a lower Sharpe Ratio can reduce your portfolio’s return potential and increase its risk.