Sharpe Ratio

Sharpe Ratio: was invented by professor William Sharpe of the USA to find the true risk-adjusted return on investment.

It is calculated subtracting the risk-free rate of return from the annual total return on an investment. The result is then divided by the volatility of the investment (beta) to arrive at the Sharpe ratio.

Sharpe Ratio = (annualized return on the investment – Risk-free rate of return)/Volatility

Volatility = (Period high – Period low)/2 X 100/Current share price

Volatility is a statistical measure of past fluctuations in the price of shares on the stock market. It is often seen as being related to the risk of the stock (many argue against this), where the more volatile the stock price–the higher your risk of losing money when trading it.

The Sharpe ratio is a elegant concept that can be applied to almost any investment that produces a return and where volatility can be calculated. Another ratio, called the Sortino ratio, is derived from the Sharpe ratio. The Sortino ratio assumes investors are not worried about total volatility, but only volatility below the mean price (where they can lose money). It is thus calculated similar to the Sharpe ratio with the same numerator, but the denominator is adjusted for only below mean deviations.