Sharpe Ratio

The golden industry standard for risk-adjusted return

What is the Sharpe Ratio?

Named after American economist, William Sharpe, the Sharpe Ratio (or Sharpe Index) is commonly used to calculate the performance of an investment by adjusting for its risk.

The higher the ratio, the greater the return of portfolio relative to the risk taken, and thus the better the investment. The ratio can be used to evaluate a single stock or investment, or an entire portfolio.

Sharpe Ratio

 

Use this premade Sharpe ratio calculator to easily calculate the ratio in Excel, or visit our Excel template section to find templates for other formulas.

 

Sharpe Ratio formula

Sharpe Ratio = (Rx – Rf) / StdDev Rx

Where:

  • Rx = Expected portfolio return
  • Rf = Risk free rate of return
  • StdDev Rx = Standard deviation of portfolio return / volatility

 

Sharpe Ratio Grading Thresholds:

  • Less than 1: Bad
  • 1 – 1.99: Adequate/good
  • 2 – 2.99: Great
  • Greater than 3: Excellent

 

What does it really mean?

It’s all about reducing volatility.  If an investment had an annual return of only 10%, but had zero volatility, it would have an infinite (or undefined) Sharpe Ratio.

Of course, it’s impossible to have zero volatility, even with a government bond (prices go up and down).  As volatility increases, the expected return has to go up significantly to compensate for that additional risk.

Below is a summary of the exponential relationship between the volatility of return and the Share Ratio.

 

 

Application of the Sharpe Ratio

An investment portfolio can consist of shares, bonds, ETFs, deposits, precious metals or other instruments. Each instrument has its underlying risk and return, which will influence the ratio.

For example, a hedge fund manager has a portfolio of stocks with a ratio of 1.70. The fund manager decides to add some commodities to diversify and modify the composition to 80/20 stock and commodities, which pushes the Sharpe ratio up to 1.90. While the addition might be risky, it pushes the ratio up and should be added to the portfolio. If the addition pushes the ratio down, the investment instrument should not have been added to the portfolio.

 

Example of the Sharpe Ratio

Another example, where there are two managers A and B. Manager A has a portfolio return of 20% while B has a return of 30%. S&P 500 performance is 10%. Although it looks like B performs better in terms of return, when we look at the Sharpe Ratio, it turns out that A has a ratio of 2 while B only 0.5. This number means B take more risk than A, which may explain his higher returns, but also means he has a higher chance of making losses.

 

Additional resources

Thanks for reading this article on measuring risk-adjusted return.  CFI’s mission is to help you advance your career in corporate finance. To continue learning and advancing your career we recommend these additional resources: