What is the Sharpe Ratio?
Sharpe Ratio Definition
Formulaically, the Sharpe Ratio is the expected returns of an asset, minus the risk-free rate, divided by the standard deviation of excess returns, which is a measure of volatility.
In other words, this formula helps an investor determine the performance of returns attributable to risk when compared to its riskiness.
Example of the Sharpe Ratio
For example, Mr. Sharpe anticipates a 13% return on his portfolio in the coming year.
He also knows the One-year US Treasury yield, which can be considered a risk-free investment, is 1.55%.
He also calculates the volatility of his portfolio as 9%.
Using these figures, he calculates a Sharpe ratio of 127%.
Now Mr. Sharpe is considering a risky investment which is projected to raise his portfolio return to 22% and volatility to 29%.
Using the same risk-free rate, the Sharpe Ratio will be 70%.
Mr. Sharpe should not make the investment because his return relative to the risk assumed is nearly half of what it was.
Stated another way, a higher Sharpe Ratio will indicate a greater return proportional to the risk taken on.
A Drawback of the Sharpe Ratio
The Sharpe Ratio is one of the most widely used efficiency ratios in modern investing due to its simplicity and usefulness in comparing investment with differing characteristics.
A drawback of using the Sharpe Ratio is that volatility, which is used in the denominator of the calculation does not necessarily equate to risk.
Therefore, an investor should consider volatility as well as other qualitative factors indicative of an investment’s risk in order to create a more accurate picture of an investment’s risk-reward profile.