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What the Sharpe Ratio Means for Investors

8 months ago
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Use this ratio to evaluate the return of an investment compared to its risk

Fact checked by Hans Daniel JaspersonReviewed by Amy Drury

The Sharpe ratio measures the risk-adjusted return on an investment or portfolio, developed by the economist William Sharpe. The Sharpe ratio can be used to evaluate the total performance of an investment portfolio or the performance of an individual stock.

The Sharpe ratio compares how well an equity investment performs to the rate of return on a risk-free investment, such as U.S. government treasury bonds or bills.

Key Takeaways

  • The Sharpe ratio compares how well an equity investment performs to the rate of return on a risk-free investment.
  • To calculate the Sharpe ratio, calculate the expected return on an investment portfolio or individual stock and then subtract the risk-free rate of return.
  • A higher Sharpe ratio may indicate good investment performance, given the risk.

<p>Alison Czinkota / Investopedia</p>

Alison Czinkota / Investopedia

Understanding the Sharpe Ratio

Since William Sharpe created the Sharpe ratio in 1966, it has been a popular risk-return measure used in finance due to its simplicity. Professor Sharpe won a Nobel Memorial Prize in Economic Sciences in 1990 for his work on the capital asset pricing model (CAPM).

The ratio compares investment opportunities or portfolios and investors to make more informed decisions by considering returns and risk. The Sharpe Ratio helps rank and indicate the expected return compared to risk:

  • Usually, any Sharpe ratio greater than 1.0 is considered acceptable to good by investors.
  • A ratio higher than 2.0 is rated as very good.
  • A ratio of 3.0 or higher is considered excellent.
  • A ratio under 1.0 is considered sub-optimal.

Warning

Certain factors can affect the Sharpe ratio. For instance, adding assets to a portfolio to better diversify it can increase the ratio. Investing in stocks with higher risk-adjusted returns can power the ratio upward. Investments with an abnormal distribution of returns can result in a flawed high ratio.

Formula

To calculate the Sharpe ratio, calculate the expected return on an investment portfolio or individual stock and then subtract the risk-free rate of return.

Divide that figure by the standard deviation of the portfolio or investment. The Sharpe ratio can be recalculated at the end of the year to examine the actual return rather than the expected return.

Sharpe Ratio Formula

Sharpe Ratio=Rx−RfStdDev Rxwhere:Rx=Expected portfolio returnRf=Risk-free rate of returnStdDev Rx=Standard derivation of theportfolio’s return or its volatilitybegin{aligned}&text{Sharpe Ratio}=frac{text{Rx}-text{Rf}}{text{StdDev Rx}}\&textbf{where:}\&text{Rx}=text{Expected portfolio return}\&text{Rf}=text{Risk-free rate of return}\&text{StdDev Rx}=text{Standard derivation of the}\&qquadquadtext{portfolio’s return or its volatility}end{aligned}

​Sharpe Ratio=StdDev RxRx−Rf​where:Rx=Expected portfolio returnRf=Risk-free rate of returnStdDev Rx=Standard derivation of theportfolio’s return or its volatility​

Example

Assume a mutual fund has an expected return over time of 25%. A risk-free rate of return is 2.70%. The standard deviation is 20%. Under these circumstances, the Sharpe ratio calculation is:

25−2.7020=1.11begin{aligned}frac{25 – 2.70}{20} = 1.11end{aligned}

2025−2.70​=1.11​

A Sharpe ratio greater than one but less than two indicates acceptable performance compared to the performance of the risk-free investment.

Using the Sharpe Ratio

  • Measure Risk-Adjusted Performance: Instead of looking at the overall return, the Sharpe ratio hones in the money made relative to the risk.
  • Compare Investments: Investors can use the Sharpe ratio to compare the risk-adjusted performance of different investments.
  • Optimize Portfolios: Portfolio managers utilize the Sharpe ratio to optimize the allocation of assets within a portfolio.
  • Evaluate Performance: Investors can evaluate whether or not the risk profile matches their risk appetite.
  • Benchmark: Investors often use the Sharpe ratio to compare the performance of a portfolio or investment against a benchmark, such as a market index.
  • Rank Risk: Investors can rank different investments or portfolios based on risk. This ranking can help identify which assets are more likely to incur losses.
  • Plan Hedging Strategies: Investors can use the Sharpe ratio to decide which assets they want to hold onto and then plan to hedge or protect themselves against potential losses.

Important

The Sharpe ratio is used in so many different contexts. The U.S. Commodities Futures Trading Commission analyzed high frequency trading activity and evaluated a Sharpe ratio of 4.3 for firms specializing in this activity.

Ratio Variations

  • Modified Sharpe Ratio: This variation modifies the traditional Sharpe ratio by replacing the standard deviation in the denominator with a downside risk measure. This places more emphasis on the downside risk.
  • Sortino Ratio: The Sortino ratio is similar to the Modified Sharpe Ratio but focuses on downside risk instead of prioritizing it. It also uses the standard deviation of negative returns in the denominator.
  • M2 Measure: The M2 Measure introduces a risk aversion parameter into the Sharpe ratio formula. It incorporates an investor’s risk preferences by allowing for a subjective assessment of risk aversion.
  • Omega Ratio: The Omega ratio considers the entire distribution of returns and calculates the probability-weighted ratio of gains to losses. It provides a more comprehensive view of risk and return.
  • Treynor Ratio: Instead of using total risk in the denominator, the Treynor ratio uses beta, which represents the systematic risk of an investment relative to the market.
  • Upside Potential Ratio (UPR): The UPR focuses on the potential upside of an investment by comparing the average gain to the average loss.

What Does a Sharpe Ratio of Less Than One Mean?

A Sharpe ratio of less than one is considered unacceptable or bad. The risk a portfolio encounters isn’t being offset well enough by its return. The higher the Sharpe ratio, the better.

Can Investors Use the Sharpe Ratio to Evaluate a Single Investment?

Yes, the Sharpe ratio is useful as a way to compare investments. It is also often used by institutional investors managing large portfolios for many investors to maximize returns without taking on excessive risk.

What Does the Sharpe Ratio Indicate?

It can indicate how well an investment in equities performs when compared to the return offered by an essentially risk-free investment over the long term. It can help improve investment decision-making as investors take steps to improve portfolio performance.

What Are the Limitations of the Sharpe Ratio?

The main problem with the Sharpe ratio is that it is accentuated by investments that don’t have a normal distribution of returns. Asset prices have zero downside but have unlimited upside potential, making their returns right-skewed or log-normal. The Sharpe ratio assumes that asset returns are normally distributed. Many hedge funds use dynamic trading strategies and options that give way to skewness and kurtosis in their distribution of returns. A simple strategy of selling deep out-of-the-money options tends to collect small premiums and pay out nothing until the “big one” hits. Until a big loss, this strategy would erroneously show a very high and favorable Sharpe ratio.

The Bottom Line

The Sharpe ratio is a metric used in finance to evaluate the risk-adjusted performance of an investment. It’s calculated as the ratio of the difference between the investment’s return and the risk-free rate to the standard deviation of its returns. Investors use the Sharpe ratio to evaluate whether an investment earns the appropriate amount of money, based on the risk.

Read the original article on Investopedia.

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