Crypto Investment Must-Know: Using the Sharpe Ratio to Assess the True Relationship Between Risk and Return

The biggest concern when investing is: Is high return truly due to smart operation, or simply because of taking big risks? This is when you need to look at the Sharpe Ratio to get a clear picture.

What exactly does the Sharpe Ratio measure?

In simple terms, the Sharpe Ratio is a tool to measure “how much return you get per unit of risk taken.” Created by economist William F. Sharpe (who also won a Nobel Prize), it helps investors distinguish whether the money earned is worth the risk undertaken.

For example, two investment options both yield a 15% return, but one has only 5% volatility, while the other has 30% volatility. Clearly, the first is more cost-effective. The Sharpe Ratio quantifies this cost-effectiveness with a number.

How to interpret the Sharpe Ratio

The higher the ratio, the better. The specific standards are as follows:

Above 1: Not bad. Indicates that the risk level matches the return, and you haven’t taken unnecessary risks.

Above 2: Quite good. The risk-adjusted return is impressive, making this type of investment generally attractive.

Above 3: Excellent. Under similar risk levels, the return is outstanding. Such investment opportunities are rare.

Below 1: Be cautious. The risk might outweigh the return, and such an investment may not be worth it.

Actual numerical comparison

Taking Investment A and Investment B as examples:

• Investment A: expected return 10%, volatility 5%
• Investment B: expected return 15%, volatility 10%
• Risk-free rate: 3%

At first glance, Investment B offers higher returns, but after calculating the Sharpe Ratio, Investment A actually performs better because it achieves its target return with less volatility.

Application in Cryptocurrency

Cryptocurrency markets are highly volatile, making the Sharpe Ratio especially meaningful for asset evaluation. For example, Bitcoin and Ethereum:

• Bitcoin: expected return 20%, standard deviation 30%
• Ethereum: expected return 30%, standard deviation 50%
• Risk-free rate: 2%

Although Ethereum has a higher return of 30%, its volatility is also much higher. After calculating the Sharpe Ratio, Bitcoin’s risk-adjusted return is actually more favorable. This is crucial for traders—if you want steady growth, choose Bitcoin; if you’re willing to accept big swings for higher returns, consider Ethereum.

Three main uses of the Sharpe Ratio in investing

Comparing different assets: Investors can use the Sharpe Ratio to compare various cryptocurrencies, funds, or portfolios horizontally. Even if returns are similar, the one with a higher Sharpe Ratio involves lower risk and is more worth considering.

Optimizing risk allocation: Want to pursue higher returns while controlling risk? The Sharpe Ratio helps you find the most efficient portfolio allocation.

Assessing market volatility periods: During bear or bull markets, the Sharpe Ratio can help distinguish whether high returns come from wise decisions or just risk-taking. This is especially useful when market conditions are unstable.

Limitations to be aware of

The Sharpe Ratio isn’t perfect:

Confuses upward and downward volatility: It considers all fluctuations as risk, regardless of whether prices go up or down. Some investors prefer the Sortino Ratio, which only accounts for downside risk.

Based on historical data: The Sharpe Ratio is a backward-looking indicator, relying on past performance to infer future results. Market conditions change, so past ratios may not accurately predict future performance.

Assumes a normal return distribution: It presumes returns are symmetrically distributed around the mean, but actual crypto assets often have irregular distributions, which can reduce the accuracy of the Sharpe Ratio.

How funds, hedge funds, and exchanges use it

Mutual funds and ETF managers often use the Sharpe Ratio as a promotional tool, allowing traders to compare risk-adjusted performance across different funds. Hedge funds, in particular, maintaining high Sharpe Ratios, often indicate superior management.

In crypto exchanges, investors can use the Sharpe Ratio to evaluate the efficiency of spot or derivatives portfolios. A cryptocurrency with a high Sharpe Ratio suggests that, relative to its risk level, it offers more competitive returns.

Final reminder

The Sharpe Ratio is a powerful tool for assessing risk-adjusted returns and helps traders make rational decisions. However, like all financial tools, it shouldn’t be relied on exclusively. It should be combined with other factors. Whether selecting cryptocurrencies, bonds, or mutual funds, the Sharpe Ratio is a core reference for building an efficient investment strategy. With a good understanding of the market and risk management awareness, you can truly achieve steady growth.