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Sharpe Ratio

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What Is the Sharpe Ratio?

The Sharpe Ratio, introduced by William F. Sharpe in 1966, is a metric utilized by investors and economists to gauge the risk-adjusted return of an investment. It quantifies the average return earned above the risk-free rate per unit of volatility or total risk. The formula for the Sharpe Ratio is:

Sharpe Ratio = (Rp - Rf) / σp

Where:

Rp = Expected portfolio return

Rf = Risk-free rate

σp = Portfolio standard deviation

Key Aspects of the Sharpe Ratio

- Risk-Adjusted Return: It measures returns in relation to the amount of risk taken. A higher Sharpe Ratio indicates better risk-adjusted performance.

- Comparison Tool: It is useful for comparing the performance of different investments or portfolios. The investment with the higher Sharpe Ratio is generally considered better in terms of risk-adjusted returns.

- Use in Portfolio Management: Widely used by fund managers and investors to evaluate and optimize portfolios. It helps in making informed investment decisions by considering both returns and risk.

Limitations

- Negative Values: Not very useful when the ratio is negative, as it can distort interpretations.

- Assumptions: Assumes returns are normally distributed, which may not always be the case.

The Sharpe Ratio is a fundamental tool in finance, assisting investors in understanding the trade-off between risk and return.

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