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StockXcel

| Jun 14, 2023

Learn about Sharpe ratio one of the most widely used statistic used by investors to assess the viability of an investment

The Sharpe ratio is a measure of risk-adjusted performance of an investment. It compares the return of an investment with its risk by dividing a portfolio's excess returns by a measure of its volatility . Excess returns are those above an industry benchmark or the risk-free rate of return . The formula for Sharpe ratio is: `Sharpe Ratio = (Rp - Rf) / σp` where `Rp` is the return of the portfolio, `Rf` is the risk-free rate, and `σp` is the standard deviation of the portfolio's excess return . A higher Sharpe ratio is better when comparing similar portfolios as it indicates either higher returns or lower volatility . However, it has inherent weaknesses and may be overstated for some investment strategies ¹. The **Sharpe ratio** has several strengths and weaknesses. Some of its strengths include its simplicity and its ability to compare investments across different types of assets ¹.

However, it also has some weaknesses. One of them is its reliance on standard deviation which is based on the normal distribution curve. Some investments may exhibit such a distribution but it cannot encompass certain strategies . Another weakness is that it treats all volatility the same, even though sharp volatility to the upside may not necessarily be a bad thing for an investor looking for a potentially rewarding investment .