What the Sharpe Ratio Means for Investors

The Sharpe ratio is a financial metric that measures the risk-adjusted return of an investment or portfolio. The ratio was developed by economist William Sharpe. A higher ratio indicates higher returns relative to the risk while lower returns indicate lower returns compared to the risk taken. It also 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.

What Is the Sharpe Ratio?

William Sharpe created the Sharpe ratio in 1966. It has been a popular risk-return measure used in finance due to its simplicity. He 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 allows investors to make more informed decisions by considering returns and risk. It can also be used to help rank and indicate the expected return compared to risk:

• 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.

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

Here are the steps to calculate the Sharpe ratio:

• Calculate the expected return on an investment portfolio or individual stock.
• Subtract the risk-free rate of return.
• Divide the result by the standard deviation of the portfolio or investment.

The Sharpe Ratio formula is pictured below:

$begin{aligned}&text{Sharpe Ratio}=frac{text{Rx}-text{Rf}}{text{StdDev Rx}}\&textbf{where:}\&text{Rx}=text{Expected portfolio return}\&text{Rf}=text{Risk-free rate of return}\&text{StdDev Rx}=text{Standard derivation of the}\&qquadquadtext{portfolio’s return or its volatility}end{aligned}$​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​

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:

$begin{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.

Factors That Influence the Sharpe Ratio

Certain factors can affect the Sharpe ratio. These include:

• Volatility: Market changes and economic swings (like company-specific news and interest rate changes) can affect the ratio by having an impact on investor risk and returns.
• Diversification: Diversifying a portfolio with a variety of asset classes like stocks, bonds, exchange-traded funds (ETFs), and mutual funds (among others) can lower the risk, which can increase the Sharpe ratio.
• Use of leverage: While the use of leverage doesn’t change the ratio itself, it does impact the level of risk to the investment itself. Remember, you are still responsible for paying back the borrowed funds. Applying leverage to an investment with a high Sharpe ratio leads to higher returns.

How to Apply 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 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, then plan to hedge or protect themselves against potential losses.

Variations of the Sharpe Ratio

• 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.

The Bottom Line

The Sharpe ratio is used in finance to evaluate an investment’s risk-adjusted performance. 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.