Developed in 1966 by Nobel Laureate William Sharpe, the ratio is used to measure and compare the level of risk in a . The higher the Sharpe ratioDeveloped in 1966 by Nobel Laureate William Sharpe, the rati... More, the better a portfolioWhat is a trading portfolio? When an investor holds a grou... More has performed relative to the risk taken.
As an example, if two portfolio managers, A and B, have enjoyed successive of 20% in the last three years, but A has a Sharpe ratio of 1.07 and B has a Sharpe ratio of 0.79, then A took on less risk than B to achieve the same return.
The Sharpe ratio tells us whether a portfolio’s returns are due to smart investmentInvestment is the commitment of money or capital to purchase... More decisions or a result of excess risk.
Visit our stocks lessons to learn more about portfolios and trading with stocks and sharesWhat is the difference between stocks and shares? The stock... More:
The formula for the Sharpe ratio
The ratio was developed by Nobel laureate William F. Sharpe in 1966. It is calculated by:
- Subtracting the risk-free interest rateWhat are interest rates in trading? When one party lends mo... More – for instance, the one given by the 10-year US Treasury bond – from the rate of return of a portfolio;
- Dividing the result by the standard deviation of the portfolio returns (the standard deviation measures the volatilityWhat is price volatility? Volatility is the price fluctuatio... More of the portfolio).
The formula is the following:
Rp – Rf / σ
Where:
Rp = expected portfolio returns
Rf = risk-free interestWhat is interest? In finance and trading, interest is a fe... More rate
σ = standard deviation of the portfolio
A simple explanation of the Sharpe ratio
Now, do not panic! This looks complex, but it has quite simple implications.
In practical terms, the Sharpe ratio asks first how much the rate of return of your portfolio is. To do this, it calculates:
Rp – Rf
This measures the difference between the return of your portfolio – usually on an annual basis – and the interest rate you would get by simply buying a 3-month US Treasury bill.
The Sharpe ratio shows two things: first, if your strategy is making more moneyMoney is a generally accepted medium of exchange to buy and... More than the risk-free interest rate; second, it relates your profits to the amount of risk you are taking. In other words, the Sharpe ratio tells you whether you are a smart traderWhat is a trader? A trader is a person who buys and sells... More or simply a risk-taker.
In other words, this part of the formula shows you if your trading or investment strategy is actually making money, or if you would be better off by forgetting about it and buying Treasury bills instead.
Now, let us say that your strategy is making more money than the interest rate you would get on a US treasury bill. At this point, the Sharpe ratio asks the second question: are you making more money because of your skills or because you are simply risking more than other investorsWhat are value stocks? A value company is a company that app... More?
To answer this question, the Sharpe ratio divides the first part of the fraction (Rp – Rf ) by the so-called standard deviation (σp).
What is the standard deviation?
In finance, this is often identified with the Greek letter known as ‘sigma’ and it is used to assess the volatility of an investment.
Calculating volatility through the standard deviation can be daunting and it should not concern us here. The important thing about this measure is that it tells us how much the return of your portfolio rises or falls compared to its mean return in a given period of time.
To put it differently, if returns are so volatile that they move up and down considerably, this means that your portfolio is exposed to a higher risk because its performance is subject to quick changes in both favourable and unfavourable directions.
How to use the Sharpe ratio effectively
Sharpe ratios work best when taking into account at least three years of a portfolio’s performance. Keep in mind that standard deviation measures the of a fund’s return in absolute terms, not relative to an . Given no other information, it’s impossible to tell whether a Sharpe ratio of 1.07 is good or bad.
Only when you compare one portfolio’s Sharpe ratio with that of another portfolio do you get a feel for its risk-adjusted return. When used in conjunction with other measures, the Sharpe ratio can help investorsWhat are value stocks? A value company is a company that app... More develop a that matches both their return needs and risk tolerance.
Sortino ratio
A variation of the Sharpe ratio is the , which removes the effects of upward priceWhat are value stocks? A value company is a company that app... More movements on the standard deviation to measure only the return against downward priceWhat is price? The price is the measure of the value of good... More volatility.
