Better understand the Sharpe ratio for optimizing the risk/return ratio
The payoff is the reward, we often hear. Trading is a perfect illustration of this. Indeed, it is necessary to take risks for buying and selling financial assets in order to realize capital gains. However, these risks must be calculated and accompanied by judicious actions in order not to turn into a disaster.
Usefulness of the Sharpes Report
The management of risk exposure is a major challenge for players in the financial sector: trading, companies, banks, etc. The various tools available here https://arya.xyz/en/blog/tips-and-advices/7-minutes-to-discover-money-management do not, however, make it possible to assess the gain obtained for each level of risk taken. To do this, the William Sharpe ratio makes it possible to identify the assets that will produce the highest return for a low level of risk.
It is defined as the excess return over the risk-free rate divided by the volatility (or standard deviation) of a portfolio. Its purpose is therefore to measure the profitability of an Alpha portfolio per unit of risk. In the end, it directs the trader’s choice between two portfolios with the same return to the one with the lowest volatility, i.e. with the lowest level of risk.
Interpretation of the Sharp ratio
The formula for calculating the ratio
Sp= (Rp – Rf) / Ecp
With Sp the Sharpe ratio of a portfolio of risk p; Rp the portfolio return; Rf the risk-free return; Ecp the standard deviation of the portfolio of risk p.
Thus, when Sp < 0, we deduce that this portfolio is less profitable than a risk-free portfolio. It then seems foolish to invest in this wreck.
In the case where 0< Sp < 1, the situation is still thinkable but so insufficient. In fact, the portfolio performs better than a risk-free portfolio.
Finally, Sp > 1 is the best situation. The performance obtained is superior to that of a risk-free investment. Thus, for 1% risk, the portfolio generates Sp% more performance than a risk-free investment.