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Sharpe Ratio: Definition, Meaning, Formula, How to Use it

Sharpe ratio helps in evaluating the risk of a mutual fund. It showcases how a fund might perform, given its risk in the market. Sharpe ratio indicates the additional returns an investor might get for investing in a fund that has high risk.

Ratios in Mutual Fund

When you invest in a mutual fund, you want to get higher returns. You diversify your investment to increase the returns and ensure its safety. Different indicators help in predicting the returns of an investment. They denote how a fund may perform in the market. The indicators also denote if the performance is better than the market. The ratios that help investors to invest in a fund that might give them higher returns are Alpha, Beta, Sharpe ratio, etc. Each ratio denotes different indicators.

Sharpe ratio denotes the performance of a fund in the market. Sharpe ratio in mutual fund indicates that the returns will be higher if the ratio is higher. It was developed by William F Sharpe, an American economist.

What is Sharpe Ratio?

Sharpe ratio helps in evaluating the performance of a mutual fund. It judges the returns of investment while assessing the risk of a fund. Sharpe ratio indicates if a fund will get you additional returns for your investment.

Sharpe ratio helps in evaluating the additional returns after adjusting it to the risk of a fund. A fund’s standard deviation can be higher if its Sharpe ratio is low. Sharpe ratio can be increased if returns get higher. An investor can earn additional returns by increasing the risk. A fund without any risk has 0 Sharpe ratio.

The Role of Sharpe Ratio in Returns of Investment

It is paramount to evaluate the risk of a fund to get higher returns. No fund is risk-free as even the cost of funds such as Government bond can increase and decrease. But it is vital that with the additional risk, you also earn additional returns.

Sharpe ratio indicates the average return of investment by subtracting the returns that are risk-free and dividing the standard deviation of an investment’s returns. You can also evaluate one stock or a fund with Sharpe ratio. The returns of an investment can be higher if the Sharpe ratio is higher after assessing the risk. Sharpe ratio showcases investors if they can earn better returns for the additional risk of their investment. It indicates that an investor should earn higher returns if they invest in funds that have a high risk.

In a down market, the Sharpe ratio plays an important role. Sharpe ratio helps in judging the performance of a fund manager by evaluating the risk. It shows how much risk a fund manager had to take to earn higher returns.

You can know the Sharpe ratio of your investment. The risk-free return from the investments is subtracted from the average returns, and you will know the additional returns. The additional returns is divided by the standard deviation of the returns. You will see the additional returns for every additional risk you take.

Sharpe ratio Formula-
Sharpe ratio = Returns on investment – Risk-free returns/Standard deviation of the returns

The fund earns 1.50% higher returns if the Sharpe ratio of the investment is 1.50 for a year. On every 1% increase in risk you take, you will earn 1.50% additional returns. You can increase your fund’s Sharpe ratio by earning higher returns if the standard deviation is high. But you will have to earn moderate returns to get a higher Sharpe ratio if the standard deviation is low.

How to use Sharpe Ratio?

You can invest in different investments such as shares, deposits, bonds, etc. The diversification of investment can play a significant role in increasing or decreasing the Sharpe ratio. For example- You earn 24% returns on your investment while the risk-free returns are 6%. The standard deviation of your investments is 8%. You will earn a Sharpe ratio of 2.0 on your investments.

Bottomline on Sharpe Ratio

Sharpe ratio helps the investors to know which funds can earn better returns if the risk taken is high. It can evaluate different funds which are in the same category. You can understand why two funds with varying levels of risk are earning the same returns.