GMAT Focus EditionData InsightsEasy
A financial analyst is evaluating the performance of three investment portfolios: Alpha, Beta, and Gamma. The analyst has collected data on their average annual returns and their respective standard deviations, which represent risk. The risk-free rate is 2%. Which portfolio has the highest risk-adjusted return, as measured by the Sharpe Ratio?
- APortfolio Alpha
- BAll portfolios have the same risk-adjusted return.
- CPortfolio Gamma
- DPortfolio Beta
Show answer & explanationAnswer & explanation
Correct answer: D. Portfolio Beta
To find the portfolio with the highest risk-adjusted return, calculate the Sharpe Ratio for each portfolio. The Sharpe Ratio is (Portfolio Return - Risk-Free Rate) / Standard Deviation. The portfolio with the highest Sharpe Ratio offers the best return for its level of risk.
Why the other options are wrong
- A. This portfolio has a lower Sharpe Ratio compared to Beta.
- B. The Sharpe Ratios for the portfolios are different, so this option is incorrect.
- C. This portfolio has a lower Sharpe Ratio compared to Beta.
Sharpe Ratio
The Sharpe Ratio measures the risk-adjusted return of an investment, indicating how much return an investor receives for each unit of risk taken.
- Higher Sharpe Ratio indicates better risk-adjusted performance.
- It uses standard deviation as a measure of total risk.
- The risk-free rate is typically the return on a short-term government bond.
Memory trick: Sharpen your returns by dividing excess by deviation!