The Sharpe ratio tells you how well an investment pays for its shakiness. When returns jump very high, they might just show more risk instead of smart investing. William Sharpe created this math tool back in 1966 from his work on pricing assets. He later won a big prize for his ideas in 1990.
You figure this number by taking what you earned above safe investments, like treasury bonds. Next, you divide that by how much your returns bounced around. This bouncing shows risk. When comparing similar funds, higher Sharpe numbers look better. The math works for past results or future guesses about how investments might do.
The formula needs three things. First, grab your total returns. Second, subtract what you could have made from risk-free places. Third, divide everything by how wildly your investment swings up and down. Fund managers use this math all the time because it helps show if they truly earn their keep or just got lucky.
Many money experts love this tool because it works simply. It shows if those extra profits came from real skill or just taking crazy chances. For example, sketchy stocks can beat blue chip companies during market frenzies. But the Sharpe ratio reveals which approach holds up better through both good and bad markets.
Smart investors watch out for tricks with this number. Some managers stretch measurement times to make risk seem smaller. Looking at yearly changes instead of daily ones almost always makes things appear safer than they really are. Market crashes happen more often than normal math suggests possible. Bad things bunch together more than these formulas expect.
Some problems arise from assuming all price moves carry equal danger. But most people fear losses far more than they worry about surprise gains. That led to new versions like the Sortino ratio, which only cares about downside dangers. Another upgrade, the Treynor ratio, focuses on market-wide risks rather than a fund's internal jumpiness.
You can use these numbers when adding new investments to your mix. Imagine your current setup made 18% last year with 12% shakiness. That gives a Sharpe ratio of 1.25 after accounting for safe alternatives. Adding a hedge fund might drop returns to 15% but cut shakiness to 8%. Your new Sharpe would rise to 1.5, showing better risk-adjusted performance.
Numbers above one generally signal good performance. However, always check against similar investments. A 1.0 ratio might disappoint when everyone else scores 1.2 or higher. The S&P 500 currently shows a ratio of 2.91, which serves as one benchmark. Remember, these numbers work best when comparing very similar investment types.
You figure this number by taking what you earned above safe investments, like treasury bonds. Next, you divide that by how much your returns bounced around. This bouncing shows risk. When comparing similar funds, higher Sharpe numbers look better. The math works for past results or future guesses about how investments might do.
The formula needs three things. First, grab your total returns. Second, subtract what you could have made from risk-free places. Third, divide everything by how wildly your investment swings up and down. Fund managers use this math all the time because it helps show if they truly earn their keep or just got lucky.
Many money experts love this tool because it works simply. It shows if those extra profits came from real skill or just taking crazy chances. For example, sketchy stocks can beat blue chip companies during market frenzies. But the Sharpe ratio reveals which approach holds up better through both good and bad markets.
Smart investors watch out for tricks with this number. Some managers stretch measurement times to make risk seem smaller. Looking at yearly changes instead of daily ones almost always makes things appear safer than they really are. Market crashes happen more often than normal math suggests possible. Bad things bunch together more than these formulas expect.
Some problems arise from assuming all price moves carry equal danger. But most people fear losses far more than they worry about surprise gains. That led to new versions like the Sortino ratio, which only cares about downside dangers. Another upgrade, the Treynor ratio, focuses on market-wide risks rather than a fund's internal jumpiness.
You can use these numbers when adding new investments to your mix. Imagine your current setup made 18% last year with 12% shakiness. That gives a Sharpe ratio of 1.25 after accounting for safe alternatives. Adding a hedge fund might drop returns to 15% but cut shakiness to 8%. Your new Sharpe would rise to 1.5, showing better risk-adjusted performance.
Numbers above one generally signal good performance. However, always check against similar investments. A 1.0 ratio might disappoint when everyone else scores 1.2 or higher. The S&P 500 currently shows a ratio of 2.91, which serves as one benchmark. Remember, these numbers work best when comparing very similar investment types.
