Understanding the Sharpe Ratio Formula and Its Practical Application in Investing

If you are an investor looking to make smart investment decisions, the term Sharpe Ratio may not be unfamiliar to you. However, if you still wonder why this criterion is necessary and how to practically apply the sharpe ratio formula, this article will help you understand clearly.

Sharpe Ratio is a measure of “worthwhile” returns relative to risk

Simply put, Sharpe Ratio is a metric that tells you how much return you get per unit of risk. Imagine comparing the price per weight of two products to see which offer is more valuable. Similarly, the Sharpe Ratio allows you to compare funds or securities fairly, not just looking at raw return figures.

How to calculate using the Sharpe Ratio Formula

If you want to calculate this manually, the formula looks like this:

Sharpe Ratio = ((Investment Return - Risk-Free Return)) ÷ Standard Deviation of Returns

where:

• Investment Return is the amount of money you receive back from your investment
• Risk-Free Return refers to the safest investment, such as a bank deposit or government bonds
• Standard Deviation measures the volatility of returns; the higher it is, the greater the risk

Clear example calculation

Suppose you are interested in 2 funds:

Fund X yields a 24% annual return but has high volatility (Standard Deviation 24%)

Fund Y yields a 12% annual return with lower volatility (Standard Deviation 8%)

Assuming the risk-free rate is 4% per year

Sharpe Ratio of Fund X = ((24% - 4%) ÷ 24% = 0.83

Sharpe Ratio of Fund Y = )(12% - 4%) ÷ 8% = 1.00

This result indicates that Fund Y is “more worthwhile” because it provides a higher return per unit of risk, even though its raw return is lower.

What is a good Sharpe Ratio?

According to general investment standards:

• Sharpe Ratio > 1.0 is considered good performance
• Sharpe Ratio > 2.0 is considered very good
• Sharpe Ratio < 1.0 may require considering alternative investment strategies

However, a higher Sharpe Ratio does not necessarily mean it suits everyone. Investors with low risk tolerance should look for funds with moderate Sharpe Ratios but lower volatility instead.

The true benefits of using the Sharpe Ratio

Helps compare funds “on equal footing” - no matter how high the returns, if accompanied by high risk, the Sharpe Ratio will reflect the reality.

Measures the skill of fund managers - good managers should generate returns while managing risk effectively, which will be reflected in a higher Sharpe Ratio.

Allows you to select investments aligned with your risk profile - you can choose funds or securities that match your risk appetite.

Caution: The Sharpe Ratio is not everything

Based on past data - the Sharpe Ratio is calculated from historical performance and does not guarantee future results.

Does not measure all risks - Standard deviation (volatility) is only one dimension of risk. Other risks, such as liquidity risk or economic risk, are not captured in the formula.

Not suitable for unconventional strategies - certain investment types, such as speculative or short-selling strategies, may not be accurately represented by the Sharpe Ratio.

Summary: The Sharpe Ratio is a useful tool but must be used correctly

The sharpe ratio formula provides a clearer picture of your investments. It indicates whether you are truly earning returns relative to the risk you are taking. Using this criterion alongside other analyses will give you a solid foundation for your investment decisions. Remember, numbers alone are not everything; understanding the fundamentals of the securities and current market conditions is also essential.