ZK Series: What is a Sharpe Ratio?
For many investors, this is the default way of making money. But what happens when the trend reverses? In many cases, those portfolios fall with it. So how can returns still be generated when prices decline?
In this edition of the ZK Series, we take a closer look at what a robust portfolio looks like, and at the strategies that can continue to generate returns even when markets are no longer supportive.
Rp = Average Return of the Porfolio
This is the average return your investment generates over a specific period (daily, monthly, yearly).
Rf = Risk-Free Rate
This is the return you could get without taking any risk. Very often, Treasury Bills (T-Bills) are being used as a Risk-Free Rate as they are fully backed by the government.
Even though people call it the Risk-free Rate and assume no risk, trading firms often disagree, as Risk-free returns don’t really exist; there are always risks.
Rp - Rf = Excess Return
By deducting the Risk-Free Rate from the Average Return, you get the Excess Return. This gives a clear indication of the additional returns the strategy or portfolio is generating.
σp = Standard Deviation
The Standard Deviation is the most common way to measure volatility. This will be measured over the same period as the Average Return of the Portfolio.
- Higher volatility = higher risk.
- Example: If a stock sometimes jumps 20% up and sometimes drops 15%, it’s riskier than a stock that sometimes jumps 5% up and sometimes drops 3%. While performance could be exactly the same between the two. The calculation of the portfolio's standard deviation is more complex and will not be explained in detail in this blog. The standard deviation is a spread score that tells you whether most numbers stay close to the average or are scattered apart.
In simple terms; “Volatility is important because even a strategy that wins 70% of the time can experience long losing streaks before the long-term projection plays out. Standard deviation measures how large those swings can be.”
Example calculation
Let's run an example calculation. We will use the following numbers:
- Rp: We will use an average return of 10% per year
- Rf: For the risk-free rate we will use a U.S. Treasury bill that returns 3% per year
- πp: The standard deviation will be set at 3.5%
To calculate the Excess Return the strategy generates, we start by deducting the Risk-Free Rate. 10% minus 3%, gives us an excess return of 7%.
Deviding the Excess Return of 7% by the Standard Deviation of 3.5%, givus us a Sharpe Ratio of 2.0.
