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Ever wondered about an easy way to figure out the potential risk of a specific stock? Then the “Sharpe-Ratio” is for you! Professional investors use the Sharpe-ratio to understand the risk of a given asset in comparison to its performance with an otherwise risk-free investment.
How the Sharpe-Ratio Works
In general, any investor that is about to invest in a given asset will only actually invest if the assets’ potential returns are higher than just leaving the money in the bank account. Leaving the money in the bank account can be seen as a risk-free investment. Also, U.S. Treasuries are generally regarded as a risk-free investment. Therefore, U.S. Treasuries serve well as a reference for a risk-free investment to calculate the Sharpe-Ratio. In order to calculate the Sharpe-Ratio, an investor will subtract this risk-free rate from the mean return of a given asset. This leaves the investor with the “excess return” that the asset generates for the additional risk that is taken in comparison to the risk-free rate.
But that is only half of the truth. For instance, as bank interest rates are at rock bottom, most potential investments will have a higher potential return than the risk-fee rate. However, stocks are in general also more volatile. Stocks can also have sharper declines in value. High volatility will lead to higher short-time losses in comparison with just investing in less volatile U.S. Treasuries. The idea of the Sharpe-Ratio is to counterbalance those effects in a single number. Hence, it does not only consi