Sharpe’s measure
Sharpe’s measure, also known as the Sharpe ratio, is a widely used risk-adjusted performance measure in finance. It was developed by William F. Sharpe, a Nobel laureate in economics, and is used to evaluate the excess return generated by an investment per unit of risk taken.
The Sharpe ratio is calculated by subtracting the risk-free rate of return from the portfolio’s average return and dividing the result by the standard deviation of the portfolio’s returns. The formula for Sharpe’s measure is as follows:
Sharpe’s Measure = (Portfolio Return – Risk-Free Rate) / Portfolio Standard Deviation
where:
- Portfolio Return is the average return of the investment portfolio.
- Risk-Free Rate is the rate of return on a risk-free investment, such as a government bond or Treasury bill. It represents the minimum return expected without taking on any additional risk.
- Portfolio Standard Deviation is a measure of the portfolio’s volatility or risk. It quantifies the dispersion of the portfolio’s returns around its average return. A higher standard deviation indicates higher volatility and risk.
The Sharpe ratio allows investors to compare the risk-adjusted performance of different investments. It provides a measure of the excess return generated by the investment relative to the level of risk taken. A higher Sharpe ratio indicates better risk-adjusted performance, as it suggests a higher excess return per unit of risk.
The Sharpe ratio is particularly useful for comparing investments with similar risk characteristics or evaluating the risk-adjusted performance of a portfolio or investment strategy. It helps investors assess the trade-off between risk and return and make informed investment decisions.