Within the field of finance, the Sharpe ratio is one of several ways in which the performance of an investment may be characterized, particularly by adjusting for the investment\u2019s risk. This metric is often used to better understand the performance of an investment portfolio. The higher a portfolio\u2019s Sharpe ratio, the better the portfolio\u2019s returns have been, relative to the risk the portfolio has taken on. Since the Sharpe ratio makes use of the standard deviation, it may be useful in comparing risk-adjusted performance across a wide variety of investment vehicles. Let\u2019s assume one is comparing a number of very distinct investment products which happen to be performing very similarly. How can you determine which portfolio is taking on more risk to achieve the same return? This is where the Sharpe ratio serves as a wonderful tool.<\/p>\n\n\n\n
In essence, if you were to measure and characterize a number of individuals\u2019
performance relative to each other, the Sharpe ratio may be able to help,
particularly because each individual may be taking on varying amounts of
risk, yet displaying the exact same performance along a certain benchmark.
In addition, the Sharpe ratio may also be helpful when comparing one\u2019s personal performance longitudinally, across several points in time.<\/p>\n\n\n\n
What are some of the use cases in which the Sharpe ratio may be meaningful to calculate, at the very least on a qualitative basis?<\/p>\n\n\n\n
Let\u2019s assume the situation in which two individuals are sharing a taxicab and happen to engage in smalltalk. A mythical third passenger in the cab happens to work at the IRS, and it just so happens that, through a strange stroke of coincidence, the IRS agent has processed both of these individuals\u2019 tax returns and knows that they both share the exact same salary. Now, assuming these two individuals each earns $70,000 USD per year, we would imagine they would be characterized as having similar \u2018performance\u2019 as wage-earners. When the taxi driver learns that one of the passengers manages a heavy metal recycling plant while the other works as a traveling salesman with a fear of flying and only travels by car, we begin to develop a better understanding of the risk involved by each of the individuals in earning their salary. Assuming the plant manager faces greater risk of disability from working around heavy metals on a long term basis, and assuming a likely lower statistical probability of the salesman having an accident, then it is reasonable to determine on a qualitative level, at the very least, that the Sharpe ratio for the traveling salesman is much higher because he is taking on less risk than the plant manager. Thus, while the taxi driver could conceivably envy both of these individuals\u2019 salary, having an awareness of each individual\u2019s Sharpe ratio (as applied to salary relative to risk of injury) the driver would not have much reason to envy the recycling manager.<\/p>\n\n\n\n
If you\u2019re a hiring manager and are faced with selecting only one candidate from a set of three individuals all having scored the same score on an aptitude test, the Sharpe ratio may come in handy.<\/p>\n\n\n\n
If you\u2019re trying to lose weight and are selecting between a variety of meal plans each containing the same set of calories, the Sharpe ratio may help you determine which of the meal plans carries most risk.<\/p>\n\n\n\n
While some folks may question the legitimacy of applying a metric from the field of finance towards the characterization of personal performance, there is little to lose, and quite a bit to gain from developing a better understanding of performance through a metric such as this. Indeed, this is
simply one of hundreds of models available upon which one can better understand and distinguish between options that may otherwise appear to be indistinguishable.<\/p>\n","protected":false},"excerpt":{"rendered":"