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Sharpe Ratio
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Sharpe Ratio

  finance:  a measure of the performance of a fund adjusted for risk where higher ratios are better;

formula:  (expected return - "risk free" return) / standard deviation of expected return
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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 short-term) are much more concerned with downside risk than upside potential.
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Associated words [difficulty]:   Sharpe Ratio
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Most commonly used in these subjects:   Business, Personal Finance
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