Question

1. Why do we maximize the Sharpe ratio when we do portfolio optimization?

Answer 1

Sharpe ratio is calculated as

(Return on asset - Risk free rate) / Standard deviation

It calculated the return a security earns above the risk free rate for every unit of risk taken. A higher sharpe ratio in the industry is considered to be superior because you are earning a higher return for the same amout of risk taken by other securities. Hence, we try to maximize the sharpe ratio in portfolio optimization. When comparing different portfolios, we should always select the portfolio with the maximum sharpe ratio as it gives a higher return for the same unit of risk.

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