The Sharpe ratio describes the extent to which an investment compensates for extra risk. This ratio is also called the risk-return ratio.
The higher the ratio, the higher the risk compensation an investment offers. Investors will therefore have a preference for investments with a high Sharpe ratio or investments that raise the entire portfolio's Sharpe ratio through diversification.
The Sharpe ratio calculates the risk-bearing return above the risk-free return, generally using the yield on AAA government bonds for risk-free return.
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