What is the Sharpe Ratio primarily used to evaluate?

The Sharpe Ratio is primarily used to evaluate excess returns relative to the risk-free rate, making it a vital tool in measuring the risk-adjusted performance of an investment. It is calculated by taking the difference between the returns of the investment and the risk-free rate, then dividing that by the investment's standard deviation of returns. This allows investors to understand how much return they are receiving for the level of risk they are assuming.

By utilizing the Sharpe Ratio, investors can compare the efficiency of different investments or portfolios. A higher Sharpe Ratio indicates a more favorable risk-return profile, suggesting that investors are being compensated adequately for the risks taken compared to a risk-free asset. This is particularly useful in portfolio management and asset allocation, where understanding risk relative to returns is paramount.

Understanding the correctly identified purpose of the Sharpe Ratio helps investors make informed decisions about where to allocate resources for optimal returns while managing risk effectively.