Risk Management #1 - Learn to Manage Your Money Right

I will talk about the concept of Sharpe Ratio.

Before that, let's examine the concepts of Expected Return and Variance for an asset.

Expected Return: For asset A, you have calculated percentage returns for 3 different scenarios using past data and future forecasts.

As a result of these calculations, you obtained +20% in case 1, +3% in case 2, and -30% in case 3.

You also calculated 25% probability for case 1, 60% probability for case 2 and 15% probability for case 3.

In this case, Expected Return = +0.2 * 0.25 + 0.03 * 0.6 - 0.3 * 0.15 = 0.023.

So, you expect a growth of 2.3% from this asset.

Also, you need to calculate Variance using historical data.

Variance = E[(μ-x)^2], where μ is the average return.

You have also calculated the Variance and found, let's say, 15%.

Great! Now we have all the numbers to calculate the Sharpe Ratio!

Sharpe Ratio = Expected Return / Variance = 0.023 / 0.15 = 0.153.

Great! You have successfully found the Sharpe Ratio! Now let's say we have another asset and you find Expected Return of 25% but Variance of 200%.

The 25% Expected Return may seem incredibly high, but if you calculate the Sharpe Ratio, you will find 0.25/2 = 0.125.

So it is less than the asset above!

What we need to understand here is that an asset can give a very high return.

However, its Variance while providing that return is just as important.

If you do not take Variance into account, you can make a big mistake and face many bad scenarios.

For you reference:

$ETH - Sharpe Ratio = -0.28

$BTC - Sharpe Ratio = +1.00

$SOL - Sharpe Ratio = +1.16