Sharpe ratio is an economic measure used by investors to evaluate an asset class’s expected return on investment with respect to its associated risk. Developed by William F. Sharpe in the mid-nineties, the Sharpe ratio is also referred to as the Sharpe Index, and it simply implies how much asset return an investor stands to gain for taking on additional risk.
It is used by fund managers and investors alike to estimate the level of risk of an investment portfolio or trading strategy and whether it is a worthy bet for positive returns. Ultimately, the higher the value of the Sharpe ratio, the higher the potential of making above-average returns from a diversified portfolio.
How is Sharpe ratio calculated?
Often defined as a measure of risk-adjusted return, the basis of the William Sharpe ratio is to estimate the excess return after all associated investment risks have been considered. It leverages a formula which simply subtracts the risk-free return rate from the average fund return and then divides it by the standard deviation of return. This ultimately gives a single digit outcome that represents how much return investors will earn for each unit of risk.
The outcome of this mathematical formula determines the viability of return on investment. Typically, a Sharpe ratio of less than one or in the negative region is considered not favourable, and a result greater than two (2) gets the pass mark. In more complex iterations of the Sharpe ratio, particularly when investment return or average return for huge portfolios, the time period of investment is also factored in.
Although the Sharpe ratio is effective in traditional finance portfolios, crypto traders rarely consider it when making investment decisions as Sharpe ratio is usually close to zero with relatively high volatility – which is almost another name for the crypto markets.