Ratios are an important part of the finance world. Ratios give predictions about many aspects of an investment. Thus, it helps the investor/trader to have a pre-trading insight of their planned investment. There are many types of ratios that investors and traders use. One such ratio is the Reward to Volatility Ratio.
What is Reward to Volatility Ratio?
The reward to volatility ratio or Sharpe ratio is a measure of risk-adjusted return 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. This ratio shows how well an equity investment performs compared 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 investors.
The Reward Volatility Ratio helps investors calculate average returns that can be expected with zero or no risk taken. That means the trader can calculate the return gained without any risk and can formulate the investment plan according to the risk he is willing to take. In addition, 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.Â
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 the help of an example
X plans to invest in securities. The expected return is 20%, 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.
How to apply Reward to Volatility Ratio?
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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 to his current portfolio. It is stated that portfolios with diversified assets can decrease 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 rewards us to a Volatility ratio of 0.86 or 86%.Â
After careful study, the investor finds out that adding the new asset or security to the portfolio will decrease the rate of return from 18% to 15%. Also, the portfolio reward volatility will drop to 10%. Assuming that the risk-free rate will remain the same gives us the Sharpe ratio of 100%, which is clearly higher than the Sharpe ratio of the previous portfolio.
The above example shows that adding diversified securities to a portfolio may have decreased the absolute return. Still, it gave a boost to the performance based on 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 compares the previous and planned future investment decisions and helps in reviewing the current investment portfolios’ performance. The higher returns can result from 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, when the R to V ratio was introduced, it has gone through 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 portfolio’s performance 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 your portfolio’s performance 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 and Treynor ratios, respectively, it uses ‘the distribution of returns below the required rate’ as its base. Also, it does not consider 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.Â
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 accurately study market conditions.
We all know that if we are willing to take risks, more trade opportunities will be available. But the Sharpe ratio works on the logic that volatility is equal to the risk. Therefore, the investor tries to increase volatility to face lesser risk, ultimately reducing the trading opportunities.
He is an expert in financial niche, long-term trading, and weekly technical levels.
The primary field of Igor's research is the application of machine learning in algorithmic trading.
Education: Computer Engineering and Ph.D. in machine learning.
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igor@forex.in.rs
