In 1966, William Sharp introduced the revolutionary concept of investment, known as the Sharp Ratio. This concept helps investors to effectively determine the return on their investment relative to its risk. In fact, with the help of this concept, in addition to evaluating the efficiency of his investment, the investor can also determine the amount of risk. Because of the importance of this ratio in the world of finance, in this Content With the help of an article published on the Hedtrid website, we will talk in detail about the Sharp ratio, its relationship to digital currencies, as well as the benefits and limitations of this concept.
It has been one of the most popular risk / return metrics among investors since its introduction into the investment world. A large part of this popularity is due to the simplicity of this criterion. Of course, after the Nobel Prize in Economics was awarded to William Sharp, the concept became even more popular among investors. The award was a reward for Sharp’s work on the Capital Asset Pricing (CAPM) model.
Now let’s see why investors should pay special attention to this ratio.
Sharp ratio and its calculation method
By calculating the Sharpe Ratio, you can determine the amount of return on investment per unit of risk. Everyone in the capital market, from day traders to long-term investors who buy and hold assets for a long time, can use this useful computational method to evaluate their performance.
Of course, performance appraisal does not mean calculating the total amount of return on investment, but determining the ratio of the amount of return to risk.
In fact, the Sharp ratio is the average amount of “adjusted profit” per unit of market volatility or total risk. Adjusted interest is the difference between the total profit and the risk-free interest rate, and the risk-free interest rate is the percentage of interest that is definitively given to the investor. For example, bank interest rates and government bond interest rates are almost risk-free and guaranteed. If we assume that the interest rate on bank or bonds is 20% per annum and on the other hand an investor can earn 70% per annum by investing in securities, then the adjusted interest rate is equal to the difference between the two numbers, ie 50 Percent, will be.
People who are involved in risky activities should pay more attention to this. In general, the larger the Sharp ratio, the more attractive the “risk-adjusted return” to the investor.
US government bonds are a good example of risk-free investment. Of course, there are differences of opinion about the following two factors:
1. Should the rate of return on the shortest-term government securities also be taken into account?
۲. Should the risk-free investment instrument be exactly in line with the time frame in which the investor expects to keep his or her investment?
In fact, the main limitation of the Sharp ratio is that it does not work on investments in which the distribution of profits is not normal. In the following, we will review the further limitations of this ratio.
Sharp ratio formula
To calculate the Sharp ratio, we use the following standard formula:
Sharpe Ratio = (Rp – Rf) / σp
Which is its Persian equivalent:
To calculate the Sharp ratio, you must subtract the risk-free interest rate (Rf) from the portfolio profit (Rp) and divide the result by the standard deviation (variance or change) of the excess portfolio (σp). Note that risk-free interest rates often refer to safe and risk-free investments such as government bonds and bank interest rates.
An important question arises here. When can we say that the calculated Sharp ratio is good? More specifically, what could indicate a high return on a relatively low-risk asset?
- Any Sharp ratio greater than 1.0 is in the acceptable to good range for investors.
- Ratios greater than 2.0 are fine.
- A ratio of 3.0 or higher is excellent.
- A ratio of less than 1.0 is lower than the standard.
Therefore Modern portfolio theoryIf you select portfolio assets in a variety of ways that there is little correlation between these assets, your portfolio risk will be reduced. So do not put all the eggs in one basket!
In portfolio diversification, instead of devoting your entire capital to a particular company, industry, or asset, you distribute it among different financial instruments and industries, thus reducing your portfolio risk. Thus, diversification can potentially increase the Sharp ratio. Just compare the Sharp ratio of your diverse portfolio with the same portfolio with little variation.
To calculate the Sharp ratio, investors must assume that the risk is equivalent to the same volatility. Of course, this does not pose a particular problem; But there is only one drawback, and that is that not all trades and investments necessarily fluctuate.
Sharp ratio applications
With Sharp ratio, you can also evaluate the previous performance of your portfolio. To do this, you must enter the statistics of previous investments in its formula. In the same way, you can predict the future performance of your portfolio; The only difference is that this time you do not know the real numbers and you have to enter the expected profit as well as the expected risk-free interest rate. In this case, the Sharpe ratio you calculate will be a probabilistic number.
The Sharp Ratio helps you find the source of your portfolio surplus profits and whether these extra profits are due to your smart investment decisions or the result of high risk you have taken. However, you can only say that your investment has been reliable if these surplus returns were achieved solely because of your intelligence and not because of high risk. Simply put, the higher the Sharp ratio of a portfolio, the better the risk adjustment performance. If the Sharp ratio is negative, there are two cases: either the risk-free interest rate was higher than the stock portfolio return or the portfolio return was negative overall. It does not matter which of the two states, no specific meaning can be given to the negative Sharp ratio.
Sortino and Trinor ratios
Sharp ratio is divided into two different branches, both of which are very useful. One is the Sortino ratio and the other is the Treynor ratio.
Sortino determines stock portfolio profit based on negative risk, but with Trinor you can get the total amount of excess return per unit of risk that the portfolio can accept.
Unlike the Sharp ratio, which takes into account the total favorable and unfavorable investment risk, Sortino deals only with undesirable risk. Sortino eliminates the effects that upward (positive) price movements have on standard deviation. For this reason, it only focuses on distributing less profit than the target profit (downward movements).
To calculate the Sortino ratio, if the formula is deducted, we subtract the risk-free interest rate from the expected profit and then divide the result by the standard deviation of the negative return on assets.
According to the formula, stock dividends are significantly lower than we expect. Why? Because we have reduced the expected profit from the portfolio profit.
The trainer ratio uses the beta coefficient or the correlation of the stock portfolio with the whole market. The trainer ratio determines whether the investor is making a profit or not. Especially if it is going to take more risk in addition to the inherent market risk.
Relationship between Sharp ratio and digital currencies
If you are familiar with digital currency trading, you know that there is a lot of risk and volatility in this market. Therefore, determining how much risk you can take will play a key role in making your trading decisions and strategies. Because digital ratios are a useful tool for measuring risk-averse returns, most digital currency traders use them. With this tool, they can have a much better understanding of the amount of risk they have to take.
With the exception of currencies such as Bitcoin and Ethereum, which have high market value and are relatively more stable than other currencies, a large number of digital currencies should be considered risky. In fact, many newer digital currencies lack the stability that Bitcoin and Ethereum have; This is because the market for these currencies is less liquid. The same is true of digital currencies such as Xerox (0x), OmiseGo, Neo and Dash. The Sharp ratio cannot eliminate this instability, but it can give us insight into their future price; Although they are completely unpredictable.
Digital Currency Trading
When it comes to trading digital currencies, we have only one risk-free rate of return. That is, you put your digital currencies in it in order to provide liquidity to an exchange. The annual profit from this work is on average 1% of the desired amount and in the form of the same digital currency that you have deposited in an exchange office.
For example, suppose the digital currency you deposit into an exchange is LightCoin. In this particular case, you will receive an average of 1% profit from depositing these light coins to an exchange. But even entrusting digital currencies to an exchange office cannot be completely “risk-free”. Why? Because there is always a risk of your account being hacked or blocked in an exchange for any reason.
Many digital currency exchanges allow traders access to APIs (APIs). Therefore, traders can use the Sharp ratio (preferably over short periods of time) to calculate the risk-reward ratio for a particular trade.
In short periods of time, Sharp Ratio can act as a risk management tool. For example, with the help of Sharp ratio you can determine whether an automated transaction should be done or not. This is great if it is possible to integrate this ratio as part of a trading algorithm. This ensures that digital currency transaction automation is incorporated alongside other traders’ risk management policies.
Remember that using the Sharp ratio does not mean that everything will go smoothly. The reason is that according to the theory black SwanNot all market events can be accurately predicted. Labor market forecasting is very difficult, especially in digital currency trading.
Limitations of Sharp Ratio
If you remember, we made a brief reference to the main limitation of this ratio and said that in the Sharp ratio formula, it should be assumed that investments have a normal profit distribution. Therefore, this ratio does not work well for those investments whose profit distribution is not normal and we need to do more research on them.
Sharp Ratio uses the standard deviation of the return on the denominator instead of the risk of the entire stock portfolio. The basic premise is that returns have a normal distribution. The normal distribution of data is very similar to rolling a dice. We know that during the various launches, the number 7 is most likely to appear. On the other hand, the numbers 2 and 12 are the least likely to appear; Because there is only one case for both of them (for 2, both dice must be 1 and for 12, both dice must be 6).
However, in financial markets, returns are usually far from average. This is because there are a lot of unpredictable ups and downs in prices. In addition, in standard deviation, it is assumed that price movements in both directions are equally risky, something that may not happen in practice.
It is easy to manipulate the Sharp ratio to manage the portfolio and improve the history of adjusted returns in terms of risk. All you have to do is increase the efficiency measurement intervals to get a more accurate assessment that is not too affected by the fluctuations. For example, the annual standard deviation of daily returns is significantly greater than the annual standard deviation of weekly returns, which in turn is more than the annual standard deviation of monthly returns.
There is another way to identify data that affects the adjusted return in terms of risk and may distort the correct information about it. In this method, it is sufficient to consider specific time periods to analyze the best possible Sharp ratio.
If you want to choose the best investments for your portfolio, you need to do risk and reward assessments at the same time. In fact, this is the main point of modern basket theory. When it comes to risk, it is the standard deviation or variance that reduces investors’ rewards (profits). So in addition to profits, you need to consider the risks in each investment decision you make.
Keep in mind that the Sharp ratio does not provide much valuable information about price movements and their forecasts. In fact, this ratio should be considered as a kind of backup tool to assess the risk / return in a portfolio. This is an important issue for everyone in the digital currency market, as they will often experience unpredictable fluctuations in this market.
All in all, Sharp Ratio is a great tool to help you find and choose the best investment with the highest possible returns, while taking into account the risks.