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The Sharpe Ratio provides a way of comparing investments within a general risk class. The ratio is typically used to project future expectations based on historic performance. For example, if comparing 2 mutual funds X and Y:
X is expected to return 8% with a standard deviation of 6%. Y is expected to return 12% with a standard deviation of 16%. If we assume a risk free return of 4% then the Sharpe Ratios for X and Y are: X = (.08.04)/.06 = .33 Y = (.12.04)/.16 = .50 The Sharpe Ratio would indicate that investment Y offers a better risk/reward tradeoff; however, it would be simplistic to make such a decision without other analysis. For example: 1. If the percentages are based on historic performance, one needs to consider how predictive that performance is. 2. Recall that a normal curve has about a 32% chance of exceeding a standard deviation. Can the investor live with that risk? Is standard deviation the measure of risk the investor wants to use? Some investors (especially in the shortterm) are much more concerned with downside risk than upside potential. 

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Sharpe Ratio
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Most commonly used in these subjects: Business, Personal Finance  
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