Ratios are an important part of the finance world. Ratios give predictions about many aspects of an investment. It helps the investor/trader to have a pre-trading insight of their planned investment. There are many types of ratios that are used by investors and traders. One such ratio is the Reward to Volatility Ratio.
The reward to volatility ratio or Sharpe ratio is a measure of risk-adjusted return which is obtained by subtracting the risk-free rate from portfolio return and then dividing this value by the excess return of the portfolio’s standard deviation. Reward to Volatility Ratio or Sharpe ratio shows how well an equity investment performs in comparison to the rate of return on a risk-free investment.
Reward Volatility Ratio, also known as Sharpe Ratio named after its founder William F. Sharpe, is a ratio that the investors use to compare the return of an investment with its risk. Since the time it was created, in 1966 it has been in use and is of massive significance to any and all kinds of investors.
The Reward Volatility Ratio helps the investors to calculate average returns that can be expected with zero or no risk taken. That means the trader can calculate the return that can be gained without any risk and can formulate the investment plan according to the risk he is willing to take. With the help of this ratio, the investor can separate the profits that are a part of the risk-related activities.
How to Calculate Reward to Volatility Ratio?
The reward to volatility ratio is obtained when the difference between the return on the portfolio and the risk-free rate is divided by the standard deviation of the portfolio’s excess return.
The formula for Reward to Volatility is, [Rp-Rf] p
Here, Rp= Return on the Portfolio
Rf= Risk-free Rate
p= standard deviation of the portfolio’s excess return
The above formula is the Reward to Volatility Ratio calculator. It is always more understandable with help of an example
X plans to invest in securities. The expected return is 20% and the standard deviation of the risk is 15% and the risk-free rate is 8%. Therefore, the reward to volatility ratio for such investment is
[0.20-0.08]0.15=0.8
The above calculations have given a reward-volatility ratio of 0.8. Does it mean that for every unit of risk that you take, you can get it again? times the amount of that risk.
Uses of Reward to Volatility Ratio
As a commonly used ratio by all the investors, Sharpe Ratio comes in handy when an investor is planning to add another asset or security in his current portfolio. It is stated that portfolios with diversified assets can result in decreased risk, also, the return is not sacrificed. One can also compare the past performance of the portfolio and the expected performance of the portfolio after adding the new assets. This could be understood with the help of an example.
The current portfolio (that has both bonds and stocks) comes with a given return rate of 18% and the risk-free rate is 5%. The standard deviation of return to the portfolio is 15%. So, this gives us a Reward to Volatility ratio of 0.86 or 86%.
After careful study, the investor finds out that adding the new asset or security to the portfolio will bring down the rate of return from 18% to 15%, and also the portfolio reward volatility will drop to 10%. Assuming that the risk-free rate will remain the same, gives us the Sharpe ratio as 100%. Which is clearly higher than the Sharpe ratio of the previous portfolio.
By the above example, it is evident that adding diversified securities to a portfolio may have decreased the absolute return but it gave a boost to the performance on the basis of risk adjustment. So, with the help of past figures and expected future figures of the investment, investors can compare the two and get an expected insight into the planned investment.
The Sharpe Ratio not only compares the previous and planned future investment decisions but also helps in reviewing the current investment portfolios’ performance. The higher returns can be a result of two possibilities i.e., either there are too many risks associated with the portfolio investment or the investment decision was taken smartly. In any case, it is advisable to go for an investment decision that is not accompanied by elevated risks, no matter how promising the expected returns may look.
The Sharpe ratio can also warn the investors about the losses that may occur with his planned investment. The risk-adjusted performance of the portfolio is directly proportionate to the Sharpe ratio. Higher the Sharpe ratio, the higher its risk-adjusted-performance. The Sharpe ratio can also be negative because of two possibilities. One, there is going to be a negative return from the portfolio. Two, the portfolio’s return rate is less than the risk-free rate.
Types of Reward to Volatility Ratio
Since 1966, the time when the R to V ratio was introduced, it has gone under many changes due to the dynamic environment. As a result, there are two types of Sharpe ratio that the investors can use. These are:-
1. Treynor Ratio
Almost developed at the same time as the Sharpe ratio, the Treynor ratio also aims at calculating the risk-adjusted return of a portfolio, but in a slightly different way. Instead of the standard deviation of the returns, it uses the beta that is the performance of the portfolio in correlation to other elements in the market. In simple words, it uses portfolio beta that exists because of the market forces.
The above explanation gives us the formula,
[Portfolio Return – Risk-Free Rate] /Portfolio Beta
It is the best tool to understand the performance of your portfolio as compared to other portfolios in the market. Investors can know if their respective portfolio is outperforming the market or not.
2. Sortino Ratio
The Sortino ratio is a lot different from that of the Sharpe ratio and the Treynor ratio. Instead of the standard deviation and portfolio beta in the Sharpe ratio and Treynor ratio respectively, it uses ‘the distribution of returns that are below the required rate’ as its base. Also, it does not take into account the risk-free rate, instead, it is calculated by subtracting the required return from the portfolio return.
The formula for Sortino Ratio is, therefore,
[Portfolio Return – Required Return] Distribution of returns that are below target return
As a result of removing the standard deviation from the formula, this ratio eliminates the impact of the upward price movement.
Limitations to Reward to Volatility Ratio
Everything comes with drawbacks and the Sharpe ratio is no exception. Even after being the choice of maximum investors, there are certain limitations to this ratio.
One of the limitations could be the possibility of receiving a negative Sharpe ratio. The reasons for such are discussed above. When this negative value approaches, the trader tries to move towards the 0 value of the ratio to get out of the negative impact. This could be done by increasing the returns, which are uncertain and cannot be controlled. So, this negative Sharpe ratio becomes useless as it cannot give an accurate study of market conditions.
We all know that if we are willing to take risks, there will be more opportunities for trade available to us. But the Sharpe ratio works on the logic that volatility is equal to the risk. Therefore, the investor tries to increase volatility in order to face lesser risk, ultimately reducing the trading opportunities.
