An American economist also a Noble Laureate, William F. Sharpe, developed the Sharpe ratio in 1966. The ratio is used by investors to measure the level of returns made on investment with the level of risk undertaken to make the returns. It also denotes the extra amount on the return that investors get with an increase in risk.

Various investments, such as the EFTS, stocks, investment portfolios, and mutual funds, use the Sharpe ratio to calculate the risk-adjusted returns. Either the rate for T-Bills or risk-free cash rates are used in the calculation of the Sharpe ratio. Sharpe ratios point out how much return an investor can expect to make form risk invested. 

What is the Importance of the Sharpe Ratio?

The ratio helps in assessing the investment managers’ performances based on risk adjustments. Let’s say that a manager may have delivered outstanding or very solid levels of return over a given period. The Sharpe ratio will answer how much risk the manager took to make those returns or whether the excess returns from an investment are due to smart decisions while investing. The more significant the Sharpe ratio is, the better the risk-adjusted-performance. A negative Sharpe ratio analysis either means the investment returns will be harmful, or the return is lesser than the risk-free rate. Either way, a negative Sharpe ration does not give any beneficial meaning. 

Qualities of a Good Sharpe Ratio

An investment’s expected returns are first calculated before calculating the Sharpe ratio on individual or portfolio investment. Then from the expected return, you subtract the risk-free rates. Using the standard deviation of the individual or portfolio investment, you then divide the sum. 

It will give the Sharpe ratio. For example, if an investment returns 25% with a standard deviation of 10% and a risk-free rate of 5%, the Sharpe balance will be 2.0.

How To Consistency Beat the Market With Over a 90% Success Rate

Whether the market is up, down, or sideways, the Option Strategies Insider membership gives traders the power to consistently beat any market. Spend less than one hour a week and do the same.

Just click the link below to see our full presentation on exactly how we do it.

CLICK HERE TO JOIN OUR FREE WEBINAR
  • A Sharpe ratio below 1.0 is said to be poor.
  • A Sharpe ratio equal to 1.0 is said to be tolerable.
  • A Sharpe ratio equal to 2.0 is said to be excellent.
  • A Sharpe ratio equal to 3.0 is said to be extremely excellent. 

The Sharpe Ratio Formula

Sharpe ratio = {R(p) – R(f)} /s(p)              

Where:
R(p) =  Return of portfolio
R(f) = Risk-free rate
s(p) = Standard deviation of portfolio’s excess return

Return

The returns used can be of different recurrence rates, for instance, daily, weekly, monthly, or even annually if their distribution is normal. However, the weakness of this ratio is that all assets are not normally distributed. When returns are not normally distributed, this formula can be hazardous. 

The risk-free rate of return

It is used to measure if there is proper compensation for the risks taken in the investment. The risk-free rate of return is measured in terms of the shortest-dated government Treasury bills. Even though this type of security has the least instability, it is argued that risk-free security should equal the comparable investment duration. Equities are an example of assets with the most prolonged duration. Should it not be equated to the long issued government inflation-protected securities (IPS)? If a long-dated inflated protected security is used, a different value for the ratio will occur. In an average rate environment, T-bills have a low real return compared to IPS.

Standard Deviation

The standard deviation of an investment is used in the Sharpe ratio to estimate adjusted returns risk. It measures the variability of the return on investment around its average return for a given period. Variability comprises both the lesser and higher returns than the mean. Investors are majorly interested in the risk or downside volatility. Investments with wide return variations from its average return have high standard deviations. The higher an investment standard deviation, the higher the return on investments needs to get a higher Sharpe ratio.

Equally, investments with consistent decent returns can match higher Sharpe ratios, even with a low standard deviation. Both the standard deviation and return are annualized. Returns are annualized by multiplying linearly by time. A monthly return of 2% when annualized will translate a return of 24%. The standard deviation of a return is a measure of uncertainty or risks of returns. Standard deviation is annualized by multiplying return by the square root of time. 

The annualized standard deviation of a monthly standard deviation of 2% will be 2%*square root of (12) =6.93%

How to Apply the Sharpe Ratio

The Sharpe ratio is mostly used to equate the variations in risk-return physiognomies when a different asset class or asset is added to the investment. For instance, investment A generates a 22% return with a risk-free rate of 3% and a standard deviation of 1%, while investment B generates a 24% return with a 3% rate and a standard deviation of 2%. The Sharpe ratio for investment A will be 19 ((22% – 3% )/ 1%), while the ratio for investment B 10.5 ((24% – 3%) / 2%). 

Since all of them have a Sharpe ratio greater than zero, it would better to invest in portfolio A than in B with a 2% deviation. Also, even though investment B has a higher return (24%) than investment A (22%), it is wise to invest in investment A as it has a higher excess return (19) than investment B (10.5). Investment A has better returns based on risk adjustment.

Limitations of Sharpe Ratio

There are two limitations to the ratio:

  1. The Sharpe ratio only considers the standard deviation as the ration for risk. Standard deviation is not a good measure for risks; of asymmetrical portfolio returns, such strategies involving options. 
  2. If the Sharpe ratio is optimistic, and there is an increase in risk undertaken, the ratio shrinks. However, when the Sharpe ratio is negative, the Sharpe ratio reduces closer zero with increased risks, which means a more significant shaper ratio. Nonetheless, this does not equate to a healthier risk-adjusted-performance.

When choosing an investment, always address the risks and rewards. It will also be wise to study its balance sheet profitability, strength, and strategic positioning. The Sharpe ratio is beneficial in evaluating the risk-adjusted performance of portfolios or stocks compared to others. It shows the best investment with maximum returns and minimized risks. One investment may earn greater returns than the other; hence it will only be a good investment decision if the returns do not come with exposure to higher risks.


Chris Douthit
Chris Douthit

Chris Douthit, MBA, CSPO, is a former professional trader for Goldman Sachs and the founder of OptionStrategiesInsider.com. His work, market predictions, and options strategies approach has been featured on NASDAQ, Seeking Alpha, Marketplace, and Hackernoon.