Sharpe Ratio
Derived by William Sharpe in 1966
Last updated
Derived by William Sharpe in 1966
Last updated
The Sharpe ratio describes how much excess return you receive for the added volatility that you tolerate for holding on to a risky asset.
It is calculated this way: S(x) = (rx-Rf)/StdDev(x) where: x = investment.
Less than 1.00
Very Low
Poor
1.00 - 1.99
High
Good
1.99 - 2.99
High
Great
3.00 or Above
High
Excellent
The Sharpe ratio is an investment analysis tool that indicates whether your risks are worth the returns your investment is providing
You'll need to know your portfolio's rate of return in order to compute the Sharpe ratio
Secondly, you'll need the rate risk-free investment, like Treasury bonds. To get the rate at which your portfolio outperforms the Treasury bond, simply subtract this risk-free rate from your portfolio's rate of return.
Finally, subtract the rate of return from the risk-free rate and divide the result by the standard deviation of the portfolio's excess return.
Return of portfolio: This is the return on investment (ROI) for your portfolio, or the expected return for a specific period of time.
Risk-free rate: This figure acts as your benchmark, or what you would've earned without virtually any risk. The Sharpe ratio often uses Treasury securities here because of their unlikeliness to default. For example, you might use a 5-year Treasury note rate to calculate the Sharpe ratio for your 5-year portfolio.
"The impetus behind the ratio is taking standard deviation and volatility to find a simple numerical value," says Randy Frederick, Schwab managing director of trading and derivatives.
Volatility is often understood as a bad thing, Frederick points out. But really, volatility means you're seeing price upsides along with downsides over time. The Sharpe ratio takes these factors and spits out a number that can tell you how your investments are doing relative to the risk.
Let's say you have an ETF with a 5-year, 30% return (Rp = 30).
Meanwhile, the 5-year Treasury has a rate of 0.83% (Rf = 0.83).
In this example, let's assume the standard deviation is 20% (σp = 20).
Now we can fill out the Sharpe ratio calculation.
Sharpe ratio = (30 – 0.83) ÷ 20
Sharpe ratio = 29.17 ÷ 20
Sharpe ratio = 1.46
With a solid Sharpe ratio of 1.46, you know the volatility your ETF weathers is being more than offset by your additional return.
Standard deviation: This measurement of volatility indicates how much a return fluctuates over a period of time. Expressed as a positive number, the accounts for both downside and upside changes.
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