It is really important to evaluate your investments and how much risk you are taking to garner your returns. There are tools that investors use to calculate this and one of those widely used tools is called the Sharpe Ratio. In simple terms, the Sharpe Ratio can determine if the portfolio’s excess returns are based on too much risk or smart investment decisions. There are other equations that investors use, but the Sharpe Ratio is most commonly used.
There are some inherent risks with using the Sharpe Ratio, such as portfolios with options, as the Sharpe Ratio fails when analyzing significant non-linear risks. But for the sake of most investors who do not invest in more advanced strategies, the Sharpe Ratio is a great tool to determine how risky your portfolio is.
If you’re not wanting to tackle equations and analyze what all this means, understand that when looking at a portfolio’s return you’ll probably want the Sharpe Ratio to be at 1 or higher. It is commonly thought that a Sharpe Ratio of over 1 is considered good. Meaning that the portfolio isn’t taking unnecessary risks to capture their returns.
In conclusion, when you’re analyzing a portfolios returns, look at the annual compounded rate of return and the Sharpe Ratio. A portfolio of 20% returns and a negative Sharpe Ratio is worse than a portfolio of 10% returns and a 1.10 Sharpe Ratio. In fact, investing a in US Treasury Bills is better than investing in any portfolio with a negative Sharpe Ratio.