Evaluating Investment Alternatives Using Performance Ratios

In this post, I look at several ratios which are used to evaluate investment performance.

The Sharpe ratio, Treynor ratio, and information ratio are all common ratios for evaluating investment managers and investment portfolios.  Each of these measures can be used ex post to evaluate past performance, or they can be used ex ante to help investors make portfolio decisions based on forecasts for various investment alternatives.

The Sharpe Ratio

The Sharpe ratio is one of the most common metrics for evaluating portfolios.

The Sharpe ratio is calculated by dividing the mean excess return of the portfolio by the standard deviation of the excess return.  In other words, this ratio measures the “reward” we can get for a particular level of variability or  “risk”.

The equation for calculating the Sharpe ratio is:

 SR=\frac{R-R_{f}}{\sigma }=\frac{E\left [ R-R_{f} \right ]}{\sqrt{var\left [ R-R_{f} \right ]}}

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