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You’ve probably heard investing professionals talk about risk-adjusted returns. This is a way of measuring the performance of an investment that factors in risk—specifically, the extra risk required to get higher returns. The Sharpe ratio is a way to measure the risk-adjusted returns of your investments.
What Is the Sharpe Ratio?
Investments can be evaluated solely in terms of their projected returns. However, you get a deeper understanding of an investment when you grasp how much risk you’ve taken on with a single stock or your whole portfolio to get those returns. This is what’s meant by risk-adjusted returns.
The Sharpe ratio—also known as the modified Sharpe ratio or the Sharpe index—is a way to measure the performance of an investment by taking risk into account. It can be used to evaluate a single security or an entire investment portfolio. In either case, the higher the ratio, the better the investment in terms of risk-adjusted returns.
By comparing the return on an investment to the extra risk associated with it above and beyond a risk-free asset—typically, a U.S. Treasury security—the Sharpe ratio gives investors a clear picture of whether higher returns are adequately compensating them for taking on additional risk.
How Does the Sharpe Ratio Work?
Investors typically have two conflicting goals. First, they always want to get the highest possible returns from their investments. Second, they aim to minimize risk, which is just another way of saying they want the lowest possible chances of losing money.
The Sharpe Ratio works by giving investors a score that tells them their risk-adjusted returns. It can be used to evaluate past performance or expected future performance, but in either case this key financial ratio helps the investor understand whether returns are due to smart decisions or just…
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