What is Sharpe Ratio?
Understanding the Sharpe Ratio and why it matters for evaluating risk-adjusted investment returns
Table of Contents
1Definition of Sharpe Ratio
Sharpe Ratio is a measure that indicates the average return earned in excess of the risk-free rate per unit of volatility or total risk. It was developed by Nobel laureate William F. Sharpe.
The Sharpe ratio characterizes how well the return of an asset compensates the investor for the risk taken. When comparing investments, the one with a higher Sharpe ratio provides better return for the same risk (or equivalently, the same return for lower risk).
The Sharpe ratio is the industry standard for measuring risk-adjusted performance, allowing investors to compare investments with different risk profiles.
2The Sharpe Ratio Formula
The formula for calculating the Sharpe Ratio is:
This formula calculates how much additional return you are receiving for the additional volatility of holding a riskier asset over a risk-free asset.
3Example Calculation
Sharpe Ratio Example
Let's say we have a portfolio with an expected return of 12% and a standard deviation of 10%. The risk-free rate is 3%.
Using the Sharpe Ratio formula: (12% - 3%) / 10% = 9% / 10% = 0.9
This means the portfolio earns 0.9 units of return in excess of the risk-free rate for each unit of volatility. Generally, a Sharpe ratio above 1.0 is considered acceptable, above 2.0 is very good, and 3.0 or higher is excellent.
4Why Sharpe Ratio Matters
Risk Adjustment
The Sharpe ratio normalizes returns by risk, providing a more complete picture than looking at returns alone.
Investment Comparison
It allows for direct comparison between investments with different risk and return profiles.
Performance Evaluation
The Sharpe ratio helps investors evaluate if a higher-return investment is worth the additional risk.
Portfolio Optimization
It guides portfolio construction by identifying assets that contribute most efficiently to overall risk-adjusted returns.
5Limitations of Sharpe Ratio
While the Sharpe ratio is widely used, it has several limitations:
- Symmetric Risk Treatment: It treats upside and downside volatility equally, penalizing positive outlier returns.
- Assumes Normal Distribution: The Sharpe ratio works best with normally distributed returns, which doesn't always reflect market reality.
- Time Period Sensitivity: Different measurement periods can yield significantly different Sharpe ratios for the same investment.
- Ignores Correlation: When comparing assets for portfolio inclusion, the Sharpe ratio doesn't account for how an asset correlates with existing portfolio holdings.