Sharpe Ratio
The Sharpe Ratio measures risk-adjusted return by comparing excess portfolio returns to volatility, helping investors assess reward versus risk.
What Is the Sharpe Ratio?
The Sharpe Ratio is a widely used financial metric that evaluates how much excess return an investment or portfolio generates for each unit of risk taken. Developed by Nobel laureate William F. Sharpe in 1966, it helps investors compare the performance of different investments by adjusting for volatility and risk.
How Does the Sharpe Ratio Work?
The Sharpe Ratio is calculated by subtracting the risk-free rate (such as government bond yields) from the portfolio’s return, then dividing that difference by the standard deviation of the portfolio’s excess returns. The formula is:
Where:
Rp = portfolio return
Rf = risk-free rate
σp = standard deviation of the portfolio’s excess return
A higher Sharpe Ratio indicates more return per unit of risk, while a lower ratio suggests less efficient risk-taking.
Why Is the Sharpe Ratio Important for Investors?
The Sharpe Ratio allows investors to:
Compare portfolios or funds with different return and risk profiles on an equal footing
Identify whether excess returns are due to smart investment decisions or simply taking on more risk
Rank strategies or managers, especially when absolute returns are similar but volatility differs
Generally, a Sharpe Ratio above 1.0 is considered good, above 2.0 very good, and above 3.0 excellent. Ratios below 1.0 are seen as sub-optimal.
Example: Sharpe Ratio in Practice
Suppose a portfolio has an annual return of 12%, a risk-free rate of 5%, and a standard deviation of 10%. The Sharpe Ratio would be:
This means the portfolio generates 0.7 units of excess return for each unit of risk taken. Comparing this to another portfolio with a higher Sharpe Ratio would indicate which investment is more efficient on a risk-adjusted basis.
When Should You Use the Sharpe Ratio?
The Sharpe Ratio is most useful:
When comparing the risk-adjusted performance of multiple funds or managers
For evaluating whether higher returns are worth the additional volatility
In due diligence, ongoing monitoring, and performance reporting for institutional or individual portfolios
