The returns an investor receives can be measured in many ways, using a number of techniques that describe the efficiency of a portfolio. Generating profitable returns is one aspect that is key to success, but the costs associated with generating those returns is an aspect of market analysis that sometime goes unnoticed. For many investors, risk adjusted returns are extremely important as excessive volatility in a portfolio can be considered problematic, which might mitigate the attractiveness of the portfolio.
In addition to strong risk management techniques, which for many traders are the use of Binary Options which have a predetermined risk reward ratio, traders need to consider the extent of the volatility associated with a specific strategy which can be evaluated by using a number of statistical metric which can help determine robustness of the risk-adjusted returns. Some of the more well-known statistical ratios are; the Sharpe Ratio, and the Information-ratio. Each of these ratios supplies an investor with a benchmark to judge the risk-adjusted returns of their portfolio.
William Sharpe created a metric in an effort to measure the accuracy of a portfolio relative to the volatility of the underlying returns. Sharpe created this ratio in an effort to measure the returns garnered as a relationship to the risk untaken. The Sharpe ratio measures risk-adjusted returns and divide this metrics by the standard deviation of the average-returns. When examining this metrics, an analyst should consider that the higher the ratio, the better the portfolio performance.
- Sharpe Ratio = (X - Y) / Z
- Where X = The average return on the portfolio
- Y = Risk-free rate
- Z = Volatility of Returns
The Sharpe ratio measures the average-return after subtracting the risk free rate, divided by the portfolio's standard deviation. The ratio creates metrics that can be used to evaluate returns within the same sector and across a spectrum of disciplines.
The index uses a level of one to specify a neutral rating. An index level of one means that the returns produced by a portfolio equal the risk assumed to produce the returns. An index level below 1 indicates that returns on an investment are worse than the risk assumed to generate that return. Additional, a Share ratio above one indicates that the portfolio is returning more than the risk taken by the portfolio manager to produce those returns.
The Information-ratio is also an attempt to improve on the Sharpe ratio. The difference within the ratios lies in the numerator which is average return minus a rate. The Sharpe ratio uses a risk free rate while the Information-ratio uses a benchmark that is more closely associated with the portfolio such as the S&P 500 in the case of a long only equity portfolio. The Information-ratio is considered an active risk metrics, as the ratio gives investors a gauge of relative performance.
Combining statistical techniques with robust investment vehicles such as Binary Options is a clear way for an investor to determine the most efficient portfolio structure.
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