What is the Sharpe ratio?
The Sharpe ratio is defined as the measure of the risk-adjusted return of a financial portfolio and is used to help investors understand the return of an investment compared to its risk. The measure assesses how much risk a trader has taken or is willing to take to generate those returns, otherwise known as the risk/reward ratio. Investors are supposed to be compensated for taking extra risk beyond holding risk-free assets.
The Sharpe ratio can be easily applied to any time series of returns without the need for additional information regarding the source of volatility and/or profitability. It is usually used to compare the risk-adjusted returns of different kind of investments like shares, ETFs, mutual funds, and investment portfolios.
Sharpe ratio vs Treynor ratio
The Treynor ratio is based on the same logic as the Sharpe ratio; however, when measuring risk level, it uses as a parameter the beta coefficient (instead of the standard deviation), which instead of measuring the total risk taken by the investor, only measures the systematic risk, i.e. the fund sensitivity to market movements and fluctuations.
Financial assets that have a beta greater than one are considered more sensitive, and therefore involve a higher level of risk than the market average; on the contrary, financial assets with a beta less than one are considered less risky than the market average. This choice is justified by the fact that specific risk can be eliminated through good diversification practices, therefore, performance assessment must be based solely on the risk component actually presented in the portfolio.
Sharpe ratio vs Sortino ratio
The difference between these two risk measures is essentially that the Sortino ratio focuses more heavily on the swings and fluctuations occurring above or below an excess return. Risk essentially revolves around the fact that the threshold rate of return desired by the investor might not be reached. The Sharpe ratio on the other hand, focuses more on variability and on the risk/return ratio.
From this point of view, it can be stated that these two indices can be used together. The Sharpe ratio can be used as the primary tool and, then the Sortino ratio can be used to analyse and make a selection between two investments that have a fairly similar Sharpe ratio.
