Monday, May 07, 2007
The Sharpe Ratio
The Sharpe Ratio
The Sharpe Ratio was created by William Sharpe in 1966 to find standard deviation of certain investments. His work was some of the most important in economics even today. Actually in 1990 he won a Nobel Peace prize for his work in economics. How’s that for credibility?
This is one of the most coveted ratios for those who want to protect assets and get the best return possible. Trendlines, PE ratios and overall market thinking are one way to gauge market returns but you need to figure some chance of loss into your investment mindset.
The Sharpe ratio allows investors to factor in risk to their portfolios. This is a little known ratio that really isn’t used much but my more mathematical investors. While you cannot truly apply this formula to one specific stock, it will work on a broader index or mutual fund. Anything but the highest of speculative investments will conform to the formula to give you a risk to reward ratio.
The ratio is best used when comparing two separate investments with differing returns. One investment vehicle may carry a higher risk, but you don’t know which investment pays the most, risk adjusted of course.
The Sharpe Ratio is:
(The investment)=(The average rate of return- the best return provided by risk free investments)/(the standard deviation of the return of the investment)
In words, the sharpe ratio is the average rate of return of your chosen investment minus the best return you can get risk free (IE savings accounts) divided by the standard deviation of the return of the investment.
About the variables:
Return
The return of the investment you wish to investigate can be from any time period. A day or a decade makes no difference as it can always be annualized. As long as the returns are normally distributed there is no difference. The kicker is, most returns aren’t for any set periods of time.
Risk free ROI
This one is often disputed. Should an investor put the amount INGDirect pays for savings accounts which is 5% or should they put the amount that T-bills are currently offering. At this point in time it makes sense to put the amount ING pays but in times or places of lower interest, T-bills might pay more but be inaccessible. In my opinion, money market accounts can also be included in the risk free genre even though they really aren’t. If a money market would collapse, you’d have more problems than just your lost money. So, I throw in MM accounts too, just for comparison.
After computing the Sharpe ratio for your investment you should end up with a number from 0-3. One being decent and 3 being amazing. You might be hard pressed to find a Sharpe ratio of three or higher just because its just too high. The ratio is easy to use and gives you a good idea of when it might be smarter to take the guaranteed money rather than gamble for a few extra percent.
The Sharpe ratio is best when used with investments that can be purchased on margin. With margin, the ratio can tell you how much more capital you should be willing to borrow to buy the investment.
The Sharpe ratio is just another way to pick investments. You don’t need to use it to pick the best of the best investments, its merely a comparison tool. Some do great with it, some do great without it.