In: Finance
What is the Sharpe approach to measuring portfolio risk? If a portfolio has a higher Sharpe measure than the market in general under the Sharpe approach, what is the implication?
Sharpe ratio measures the risk adjusted return of a portfolio and it is calculated by reducing the risk free return from the portfolio return and then dividing the result with the standard deviation of the portfolio. The idea behind this is that the since the risk free return can be earned without taking any risk (like treasuries which do not have any default risk), a portfolio (or portfolio manager) should be adjudged on how much excess return has been generated over and above the the risk free rate per unit of the risk where risk is measured by the portfolio standard deviation. It denotes how much return (compensation) an investor is getting by taking incremental risk over and above risk free rate. It is also very important when comparing two portfolios - the one with higher sharpe ratio that is higher excess return per unit of risk should be preferred . Note that the ratio assumes uniform (normal) risk distribution. The Sharpe ratio can also help us understand when comparing various investment portfolio on whether a portfolio has higher return due to better fund manager or due taking higher degree of risk.
If a portfolio has higher sharpe ratio than the market, it means that the it has superior portfolio / stock selection and it is able deliver better returns per unit of risk compared to the market in general.