Investing with the Sharp ratio

The Sharp ratio is a measure to asses risk in the financial markets invented by William F. Sharpe.

This ratio tries to measure the generated return with respect tovolatility.

This would be some indication of the supposed returns investors should expect for a certain volatility.

The formula used would be something like this:

Sharpe = (Rp – Rf)/D

Where Rp would be the expected return, Rf the return without risk (treasuries and state bonds) and D would be the standard deviation of the portfolio.

The Sharp Ratio

Remember that the standard deviation is a measure of the average return of an asset considering its volatility. The more volatility the more standard deviation you will have.

Therefore, when we have low volatility, the standard deviation will be low and if we get the same return that other asset with more volatility then the Sharpe Ratio will show us that.

Let us see an example:

We have the portfolios X and Y.

X has an average return of 15% and Y of 10%.

The standard deviation of X is 15% and of Y is 5%.

Hence, at first sight it seems that X is much better portfolio than Y because of the bigger return.

However, if we see the matter from a risk perspective with standard deviation we will see that the portfolio X incurs in bigger risks than Y, at least triple the risk.

If we take as a reference of “no risk asset” a 6% return, we would have the next result:

Sharpe portfolio X = (15 – 6)/15 = 0.6

Sharpe portfolio Y = (10 – 6)/5 = 0.8

In this case the Sharpe ratio tells us that porftolio Y gives us a better return for the volatility expected.

X gives us more returns but we pay the price of having more volatility.

Y would be one traditional stock of one of the major world indexes, a stock that pays significant dividends and is seen as secure.

On the other hand X would be a company of smaller capitalization with fewer or non existend dividends.

Even though it is a good ratio to gives us information about risk, especially when comparing assets from the same group, it is not a secret formula to succeed in the financial markets, although the fact that someone is using it is a good sign, since it means that the person is interesting in long-term investing.

As we should know, short-term trading is a complicated example full of lies.

In other words, it is better to use the Sharpe ratio for long or medium-term investing than using the RSI for short-term trading.