• The Sharpe ratio measures how much extra return an investment makes per unit of risk taken.
• You can calculate it by taking the investment’s return and subtracting the return of a super-safe investment, then dividing the result by the investment’s return volatility.
• A higher Sharpe ratio means the investment has better historical returns, adjusting for its risk level.
• This metric is widely used in finance to communicate return versus risk.
• However, it also often underestimates potential big losses and sometimes fails to explain why returns happened.

The Sharpe ratio shows the performance of an investment by adjusting for its risk. Specifically, it calculates the amount of excess return per unit of risk in an investment asset or strategy.

It answers the question:

“Is the extra reward worth the risk?”

The investor uses the Sharpe ratio to determine if an investment’s returns are due to smart investment choices or as a result of taking greater risks. For example, between two funds with 10% returns, the one achieving that return with lower risk would have superior risk-adjusted returns and thus a higher Sharpe ratio.

However, this simplicity comes at a cost. It might not be able to show big downside risks and doesn’t explain what drives returns. So, investors should also look at other stats like alpha, beta, R-squared, and max drawdowns, which give more detail on returns and risks when comparing investments.

Nobel laureate William F. Sharpe created the Sharpe ratio in 1966 to compare investments with significantly different risk profiles. The ratio allows for comparing very different investments based on their returns versus risk.

How to Calculate the Sharpe Ratio

To calculate the Sharpe ratio, first take the investment’s return. Then subtract the return of a super-safe investment (such as a 3-month Treasury bill). Next, divide that by the investment’s return volatility, or standard deviation.

In formula form:

Sharpe Ratio = (ER – RF) / Standard Deviation

Where:

• ER (Expected Return): The historical or expected rate of return of the investment asset or portfolio.
• RF (Risk-Free Return): The return on an investment with no financial loss, traditionally government securities with short maturities (such as 3-month U.S. T-bills).
• Standard Deviation (of Excess Returns): This figure measures how much an investment’s returns bounce up and down from its average return. It shows how volatile or “bumpy” the returns are.

A higher resulting ratio means better returns after adjusting for how aggressive or risky the investment is. So, if comparing similar investments, the one with a higher Sharpe ratio performs better for the amount of risk taken.

There is no absolute threshold for determining what represents a “good” or “bad” Sharpe ratio.

Generally, a higher Sharpe ratio indicates superior historical risk-adjusted performance. For example, in mutual funds, 1.0 or higher is good. Meanwhile, a negative Sharpe ratio indicates that the prospective investment would have lower returns than the risk-free asset relative to risk.

However, proper benchmarking is essential for meaningful interpretation. Comparing the Sharpe ratio of large-cap equity mutual funds to that of small-cap funds wouldn’t be accurate, so industry benchmarks in similar categories provide a better context for comparison.

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Pros

• It can compare investments with different returns or volatility.
• Easy to compute with known expected returns and risk measures.
• Applicable to individual assets, funds, or trading strategies.
• Helpful for comparing investment managers with different risk strategies.

Cons

• Relies on assumptions about expected returns, volatility, and the risk-free rate.
• May underestimate total risk by only considering standard deviation.
• Hard to use effectively for non-normally distributed returns.
• Requires proper benchmarks to make sense.
• Not effective for assessing investments with uneven return profiles.
• Focuses solely on reward-to-risk ratio, ignoring other performance metrics.

Many players in investing, from individuals to large institutions, routinely calculate and analyze Sharpe ratios as part of assessing where to put their money.

Regulators like the SEC mandate mutual funds to disclose Sharpe ratios to clients, along with other return metrics like alpha and beta. Meanwhile, financial analysts publishing academic studies on investment or trading strategies routinely use the Sharpe ratio to compare investments. It’s also commonly featured in presentations, fund marketing literature, and investment consultant reports.

Still, it’s a good idea to use other performance metrics when an investor does due diligence to determine if an investment is worth the money.

Sharpe Ratio Example

Consider two mutual funds: Fund A and Fund B. Let’s use the Sharpe ratio to compare which fund did better over five years.

Suppose these are true:

• Fund A made more money on average (25% per year) but was riskier (its returns varied a lot, by 20%).
• Fund B made less money on average (15% per year) but was less risky (its returns varied less, by 10%).

We also consider what you could have earned with very low risk by investing in something safe like 5-year Treasury bonds, which gave a 2% return.

Using the formula above, we can see that:

• For Fund A, the ratio is 1.15.
• For Fund B, it’s 1.30.

Even though Fund A made more money overall, Fund B has a higher Sharpe ratio. This means for every bit of risk taken, Fund B gave more extra return compared to the safe option. On the other hand, despite its high returns, Fund A was more volatile, while Fund B showed good returns for the amount of risk involved.

In conclusion, if an investor wants to make a decent return without taking too much risk, Fund B might be the better choice.

What are some notable limitations of the Sharpe ratio?

The Sharpe ratio has some limitations. It measures risk using standard deviation, but this doesn’t cover the risk of big, rare losses. It’s also hard to use when investment returns aren’t consistent, nor does it tell you why an investment did well (or didn’t).

Finally, when comparing Sharpe ratios of different investments, it’s important to compare similar ones to get as close to an “apples-to-apples” comparison as possible.

Why do investment managers focus so heavily on the Sharpe ratio?

Investment and fund managers like the Sharpe ratio because it’s simple. It gives them an easy way to tell clients about their investment’s past returns after considering risk. Higher figures help managers demonstrate that their investment strategies were successful, even after adjusting for different levels of risk.

What are simpler alternatives to Sharpe ratios for individual investors?

For less experienced investors, it’s not necessary to calculate Sharpe ratios. You can use simpler ways to understand risk-adjusted returns. Looking at how often the portfolio has positive returns each month or the biggest drop in value it has ever had can be helpful.

In addition, comparing the yearly returns of your investment to those of a similar index fund that’s not actively managed is an easy way to see if paying extra for an active manager is worth it.