The Sharpe Ratio is a risk-weighted metric for returns on investment. It measures whether an investment offers a good return for the amount of risk assumed by the investor. The risk/return trade-off is a positive linear relationship in most theoretical depictions – if an investor seeks greater returns, they will have to take on greater risk. For more stability and less risk, an investor will have to sacrifice some potential returns.
The Sharpe Ratio is widely used by investors to calculate risk-adjusted return – its developer, William Sharpe, won a Nobel Prize winner for the Capital Asset Pricing Model (CAPM), so the processes and theories behind the Sharpe Ratio were already well-known. It aims to reduce the two measures of mean and variance into one value indicating how much return is expected relative to the amount of risk being taken.
The Security Market Line (SML) is the visualization of the Capital Asset Pricing Model. It shows the theoretical relationship between risk and return between securities and the entire market. The SML is plotted on a graph bound by an x-axis, which represents Beta (volatility above or below the market average), and a y-axis, which represents the rate of return. Almost all securities will fall around the line but rarely directly on it.
The Sharpe Ratio helps illustrate the standard deviation of a security from the SML and how much return (over the risk-free rate) is gained. The ratio is computed by dividing the standard deviation of a security by its rate of return (minus the current risk-free rate of return, or 10-year treasury yield). The higher the ratio, the more the investor is being compensated for the amount of risk they assume.
Like any investment tool, the Sharpe Ratio has limitations. It is predicated on the idea that returns are normally distributed, but financial markets tend to deviate from the average because of their inherent unpredictability. It can also be manipulated to show lower volatility by extending the time period it measures, smoothing out the daily peaks and valleys of a security.
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