SR helps you understand the returns of a strategy/portfolio in relation to the risks taken to gain these returns.
About
If you have two investments with two different SRs, the one with the higher SR is giving you either:
- Better return for the same risk
- Same return for less risk
Risks taken are compared with the Risk Free rate of return. In theory you could use any measure of “Risk Free” e.g. putting your money in a bank account with 3% interest per annum (assuming a bank is risk free). The SR in this case is telling you how well you did compared with putting your money in the bank and factors in how much risk you took in doing so.
Notes/Assumptions:
- Investment returns are normally distributed
- Risk is equal to volatility
- Diversification should increase a portfolios SR
Equation
- p = Percentage change returns
- f = Risk Free Rate
- σp = Standard Deviation of Rp
It is not recommended to use the return on a buy & hold strategy of the market index as a value for `f` because this is not considered a risk free rate of return. This type of comparison is left for the Information Ratio and the Modigilian Ratios.
Annualised Sharpe Ratio (SRa)
The Annualised Sharpe Ratio (SRa) is helpful when comparing various strategies that use multiple years of data. An interesting article can be found here.
Code
Below is the python code to calculate the SR. To access the maintained version of this code please see python library backmet.
Links
- backmet TestPyPi – link
