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Understanding Sharpe ratio and its importance while taking investment decisions

Developed by Nobel laureate William Sharpe, the Sharpe ratio is used to understand the returns earned on an investment compared to its risk. Risks and returns have a direct relation – the higher the potential return, the greater the risk. Calculating Sharpe ratio is one of the easiest methods to measure the investment returns given the level of risk taken.

What is Sharpe ratio and why is it important?

Sharpe ratio in mutual funds helps investors to know about returns on their investments as against the risks taken to earn those returns. The ratio is useful to compare the risk-adjusted returns of different investments such as mutual funds, stock market, deposits, bonds, and other investment avenues. This ratio comprises three variables – expected return, standard deviation, and the risk-free rate of return.

Sharpe ratio is calculated with the below formula:

Sharpe ratio = (Rate of return on investment – Risk-free return) / Standard deviation of returns

For example, a fund named ABC gave a return of 15%, risk-free return was 5% and the risk factor (standard deviation) was 30%. Based on the formula above,

= (15%-5%) / 30%

= 10%/ 30%

= 0.33

Fund ABC generated 0.33 units of return for the risk undertaken.

Benefits of Sharpe ratio in the investment sector

Investors can use this equation to evaluate risks against returns and make smart investment choices. When it comes to mutual funds investment, a fund without any risk has a 0 Sharpe ratio. Similarly, if the ratio is higher, the returns will also be greater.

What is a good Sharpe ratio for a mutual fund?

Any Sharpe ratio of 3.0 or more is considered excellent by investors. A ratio above 2.0 is termed good, and a ratio greater than 1.0 is near to acceptable. A Sharpe ratio of less than 1 is said to be poor. 

Sharpe ratio and its importance for investors 

Along with any other ways to evaluate if the investment instrument of choice is good for your investment or not, you should also look at Sharpe ratio for the chosen instruments. Sharpe ratio is a popular risk measuring method that you could use to make smarter investment choices. If calculating Sharpe ratio, assessing the performance of securities seem a bit too complicated or time-consuming for you, you could also explore your investment options with a financial advisor to create a diverse portfolio based on your risk appetite and financial goals.