Why is the Sharpe Ratio an essential indicator that investors need to know

Sharp Ratio is a tool to truly measure the profitability of an investment

When deciding to choose a fund or security, many people tend to look only at the return figures. Seeing a 20% return, they quickly become interested, not knowing how much risk is hidden behind that number. This is where Sharpe Ratio comes into play. It is a financial indicator that helps you see the real picture of whether the return you receive is worth the risk you take.

Think simply: if you have to choose between cheap milk that gives you 1 bottle or expensive milk that gives you 5 bottles, you want to know how much each bottle costs to be worthwhile. The Sharpe Ratio does the same thing, but compares securities to see which one provides the most worthwhile return relative to the risk you bear.

Fund A vs. B, which one is truly worth investing in?

Suppose this year, Fund A yields a 20% return per year, and Fund B yields 10% per year. At first glance, most people would choose A because the number is higher. But that might be a wrong choice.

To see clearly, let’s calculate the Sharpe Ratio.

Formula: Sharpe Ratio = ((Return - Risk-Free Rate)) ÷ Standard Deviation

In this case:

• Return = the return of the considered fund
• Risk-Free Rate = 5% (such as bank deposit interest rate)
• Standard Deviation = the volatility of the return

Fund A: Volatility 20% Sharpe Ratio = ((20% - 5%)) ÷ 20% = 0.75

Fund B: Volatility 10% Sharpe Ratio = ((10% - 5%)) ÷ 10% = 0.50

Result! Fund A has a Sharpe Ratio of 0.75, higher than Fund B’s 0.50. This indicates that Fund A offers a more worthwhile return relative to the risk investors face.

But where can you find the Sharpe Ratio?

The good news is you don’t have to calculate it yourself. Most mutual fund and security providers publish the Sharpe Ratio on their official websites under performance data. You can check immediately. If a fund does not have this information, you can calculate it yourself using the formula introduced earlier.

What is a good Sharpe Ratio?

Generally, a good Sharpe Ratio should be greater than 1. It means that the fund or security provides excess returns over risk by more than 1% per year.

But remember, a high Sharpe Ratio doesn’t mean low risk, and a low Sharpe Ratio isn’t necessarily bad. Everything depends on the level of risk you are willing to accept. Older investors with lower risk tolerance should look for funds with a moderate Sharpe Ratio but lower risk as well.

Why is the Sharpe Ratio important for investors?

1. Fair comparison of different securities

Imagine you need to choose among three funds with different returns. Just looking at the return numbers can be confusing. The Sharpe Ratio helps you compare them on a level playing field, providing a more accurate assessment than just looking at the raw numbers.

2. Measures the true skill of fund managers

Skilled fund managers often do not just generate high returns. They manage to produce those returns with lower risk. Therefore, a high Sharpe Ratio can be proof that the manager truly knows what they are doing.

3. Enables informed decision-making

Instead of investing based on emotions or following others, the Sharpe Ratio provides a clear numerical basis for your decisions. It’s like having a map instead of wandering blindly in the forest.

What should you watch out for when using the Sharpe Ratio?

1. The Sharpe Ratio is based on historical data

This is a major weakness. The Sharpe Ratio you see today only reflects past performance. It does not guarantee the future will be the same. Funds may have turned around or shifted to new assets, so you need to monitor regularly.

2. It only measures part of the risk

Risk is not just price volatility (Standard Deviation). There are liquidity risks, economic risks, credit risks, and many others. The Sharpe Ratio does not capture these, so investors should study further.

3. Misinterpretation with high-risk funds

A high Sharpe Ratio does not always mean low risk. Some funds with high Sharpe Ratios may involve “playing with fire” risks. If you are uncomfortable with risk, do not go against your own risk appetite.

A brief summary to understand what the Sharp Ratio is

Sharp Ratio is a decision-making tool that tells you how worthwhile the returns promised by a fund or security are relative to the risk you bear.

The basic calculation is simple: (Return - Base interest rate) ÷ Volatility. Once you remember this unit, you can analyze funds systematically.

The higher the Sharpe Ratio, the more you can expect your investment to be valuable. But remember, it is only a decision aid. Always consider other factors to ensure your investments are safe and rational.