The Sharpe ratio, developed by Nobel laureate William F. Sharpe, is a measure used to calculate the risk-adjusted return of an investment. It shows how much excess return is being received for the additional volatility endured for holding a riskier asset, compared to a risk-free asset like government bonds.
The Sharpe ratio allows investors to understand the return of an investment compared to its risk. A higher Sharpe ratio indicates a more favourable risk-return profile, suggesting that the investment is providing higher returns per unit of risk. This metric is particularly valuable in comparing the performance of different investments or portfolio strategies.
In using the Sharpe ratio, investors should be mindful that it is based on historical data and assumes that investment returns are normally distributed, which may not always be the case. Additionally, the ratio can be influenced by the choice of risk-free rate and the time period considered. Hence, while informative, the Sharpe ratio should be used alongside other metrics and qualitative factors in comprehensive investment analysis.
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