How does the Sharpe ratio help in evaluating an investment strategy?
The Sharpe ratio helps investors measure the risk-adjusted return of an investment.
It tells you how much excess return (return above the risk-free rate) you’re earning for each unit of risk taken.
Formula:
Why is it useful?
- A higher Sharpe ratio indicates better risk-adjusted returns.
- A lower Sharpe ratio suggests that the risk taken is not justified by the returns.
- Helps compare different funds or portfolios on a fair basis by considering volatility.
Example:
If Fund A has a Sharpe ratio of 1.5 and Fund B has 0.8, Fund A has better risk-adjusted returns, even if their raw returns are similar.
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