In our previous posts on risk we examined the definition of risk and how to measure risk. In this post we will examine how to measure risk and return through statistics by examining ways to compare the risk-adjusted performance of investments with differing risk and return profiles. Incorporating these ideas will help you determine the most appropriate investment choices for your clients.
The Sharpe ratio, developed by Nobel Laureate William F. Sharpe, is a statistic which measures risk-adjusted performance. The ratio expresses how much additional return is received from an investment portfolio for each additional unit of risk taken on. It is calculated by subtracting the risk free rate of return, such as the 3-month T-bill rate, from the rate of return for an investment and dividing by the standard deviation of the portfolio returns.