# The Sharpe Ratio: A measure of investment performance

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Sharpe Ratio measures the risk adjusted return of a portfolio. The ratio quantifies the excess return per unit of the risk (Standard Deviation of the returns of a portfolio) in comparison to the returns on risk free investment.

In simple terms, Sharpe ratio helps investor to ascertain the incremental return of a risky portfolio over and above the risk free asset like government bond or fixed deposits.

Formula for Sharpe Ratio: Below is the formula for calculating the Sharpe ratio:

{R (p) – R (f)} /StdDev(p)

Where

R (p): Portfolio return

R (f): Risk free rate of return (Generally on government bond or fixed deposits)

StdDev(p): Standard deviation of the portfolio

The numerator in the above formula i.e. R (p) – R (f) computes the excess return of the portfolio which is further divided by standard deviation of the returns of portfolio.  Generally, the risk inherent in an investment is determined using standard deviation of the returns of a portfolio. So, Sharpe ratio gives us excess return per unit of risk taken by the investor.

Thus, a higher Sharpe ratio indicates better return yielding capacity of a fund for every additional unit of risk taken by it.

Significance of Sharpe Ratio: Sharpe ratio indicates the investor’s willingness to earn higher return than the lower returns provided by risk free assets.

Sharpe Ratio- A measure of fund comparison: Sharpe ratio can be used to compare funds falling into same categories; like comparing returns on large-cap equity funds. By looking at the Sharpe ratio we can assess the return per unit of risk taken and decide upon the preferred fund investment.

As higher Sharpe ratio indicates the better return capabilities of funds.