Sharpe Ratio is a measure of investment profitability that investors need to know

If you’ve ever hesitated about which fund to invest in or wondered which stock is more worth investing in, the answer might lie in a single indicator called the Sharpe ratio. It’s a tool that helps you make rational investment decisions without relying solely on feelings or rumors. This article will introduce you to this important metric in detail.

What is the Sharpe Ratio? In simple terms

Imagine you have 100,000 THB and need to choose between a “fund with a 20% return but high volatility and risk” and a “fund with a 15% return but lower volatility.” Which should you pick?

The Sharpe ratio provides the answer. It’s a measure that tells you how much return you get per unit of risk taken — in other words, “Is it worth the risk?”

It’s like choosing milk: if a small box costs more per unit, but a larger box costs less per unit, you know which to choose. Similarly, in investing, a higher Sharpe ratio means better value for the risk you’re taking.

How to calculate the Sharpe Ratio — simple formula

The basic formula of the Sharpe ratio isn’t as complicated as university-level math:

Sharpe Ratio = (Investment Return – Risk-Free Rate) ÷ Volatility

Where:

• Investment Return = profit earned over a specific period (e.g., 20% per year)
• Risk-Free Rate = return with no risk, such as bank deposit interest or government bonds (about 5% per year)
• Volatility (Standard Deviation) = a number indicating how much returns fluctuate; higher = more fluctuation = more risk

Example calculation for clarity

Suppose you’re considering “Fund A” and “Fund B”:

Data:

• Fund A: 20% annual return, 20% volatility
• Fund B: 10% annual return, 10% volatility
• Risk-free rate: 5%

Calculations:

Fund A: Sharpe Ratio = (20% – 5%) ÷ 20% = 15% ÷ 20% = 0.75

Fund B: Sharpe Ratio = (10% – 5%) ÷ 10% = 5% ÷ 10% = 0.5

Result: Fund A has a higher Sharpe ratio (0.75) than Fund B (0.5), indicating that despite higher risk, Fund A offers better risk-adjusted returns.

How good is a Sharpe Ratio? What’s considered favorable?

A good Sharpe ratio is above 1.0, meaning you earn more than 1% of excess return for each unit of risk.

Evaluation criteria:

• > 1.0 = Very good (worth the risk)
• 0.5 – 1.0 = Moderate (considerable)
• < 0.5 = Low (may not be worth the risk)

However, remember that the Sharpe ratio is just one indicator. Don’t rely solely on it; consider other factors like fund manager performance history, fees, and investment policies.

5 key benefits of the Sharpe Ratio

1. Fair comparison of investments

It provides an unbiased way to compare different funds or assets by considering both returns and risk, not just the return figures.

2. Measures fund manager skill

A high Sharpe ratio suggests the manager can generate good returns without taking excessive risk, indicating skill.

3. Helps match investments to your risk level

Investors with low risk tolerance should look for funds with high Sharpe ratios, ensuring better risk-adjusted returns even if the absolute returns are lower.

4. Supports rational decision-making

By focusing on numbers rather than emotions or rumors, it helps you make logical investment choices.

5. Applicable across all investment types

Whether stocks, mutual funds, or digital assets, the Sharpe ratio is a versatile tool.

Precautions before using the Sharpe Ratio

1. Based on historical data, not future predictions

A high Sharpe ratio in the past doesn’t guarantee future performance. Markets change, so continuous monitoring is necessary.

2. Doesn’t capture all risks

It measures volatility but doesn’t account for other risks like liquidity issues, economic crises, or political changes.

3. Can mislead with high-risk funds

Funds with high Sharpe ratios often carry higher risks. Risk-averse investors should be cautious and prefer moderate or low-risk funds.

4. Compare only similar assets

Don’t compare the Sharpe ratio of stocks with bonds, as their risk profiles differ significantly. Always compare within the same asset class.

Summary: The importance of the Sharpe Ratio

The Sharpe ratio is a vital financial metric that shows whether an investment’s return justifies its risk. The higher the ratio, the better the risk-adjusted performance.

Use it to compare similar funds or assets to find the most efficient investment. Remember, it’s just one piece of the puzzle — always consider other factors to make well-informed decisions aligned with your financial goals.