The Sharpe ratio calculates the return that an investor will receive for an investment, compared to its risk. It allows investors to quickly identify the risk profile of individual stocks.
It is calculated by substracting the risk-free rate from the return of a stock. The sum of that calculation is then divided by the standard deviation of that stock, to give you the Sharpe ratio.
For example, if the risk-free rate is 1%, the return of a stock is 15% and its standard deviation is 12%, then the Sharpe ratio would be (15% – 1%) ÷ 12% = 1.167.
A Sharpe ratio of 1 is considered good, a Sharpe ratio of 2 or above is considered very good, while a Sharpe Ratio of 3 or above is considered outstanding.
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