As they say, “the greater the risk, the greater the reward,” which is why treasury bonds will pay you less than debt issued by a silicon startup; the odds of losing your investment with the startup is much higher, so the startup offers more to allure your investment dollars.
In finance, we use Sharpe ratio to summarize that risk/reward relationship.
The Sharpe ratio help investors understand the reward they’re receive for taking on the additional risk when investing in anything but a risk-free investment.
To calculate the Sharpe ratio of an investment, we subtract the risk-fee rate from the average rate of return, and divide it by the standard deviation. Here’s the formula, don’t worry, it’s not as complex as it looks…
The numerator starts with the risk-free rate, which is the rate of return of a hypothetical investment with no risk of financial loss – and typically this is treasury bills or bond.
We proceed by subtracting the risk-free rate by the average rate of return. The average rate of return, is the sum of annual returns, divided by the number of years since inception.
In the denominator, we have the standard deviation, which is a measurement of volatility, or risk, and is figured by averaging the distance between the highs and lows an investments encounter via systematic and unsystematic risk. If you’re curious about how standard deviation or systematic and unsystematic risk, head back to our channel and look for their titles.
So, if we assume the risk-free rate to be 1%, our annual average return to be 8%, and our standard deviation to be 5.5, we can begin our calculation.
We start with our numerator, subtracting our 1% risk-free rate from our annual average of 8%, rendering 7%.
We then divide by our denominator of 5.5, providing us a Sharpe Ratio of 1.28 – this would be an investment worth investigating.
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