Calculate the Sharpe Ratio
The Sharpe Ratio is a formula developed by Nobel laureate William F. Sharpe to measure risk-adjusted performance by examining the additional return received for the added volatility of a higher-risk asset. A high Sharpe Ratio indicates a greater return for each unit of risk. By examining the Sharpe Ratio, an investor can make theoretical comparisons of risk-adjusted returns of portfolios or investments that have varying returns and levels of risk. The higher the Sharpe Ratio, the better. A negative value of the Sharpe Ratio means that a risk-less asset offers better performance than the investment being examined.
Calculate the Sharpe Ratio
The formula for the Sharpe Ratio can be written as:
Sharpe Ratio = (Expected Return – Risk-Free Return) / Standard Deviation
The numerator of calculates the expected return of the investment beyond the risk-free rate that is available (such as the current rate of a U.S. treasury bond).
Click here to launch an Expected Return calculator and click here for available bond rates.
The denominator is the standard deviation of the portfolio or investment being analyzed. Standard deviation is a statistics term that is used to measure variability of a set of data. A low standard deviation indicates that the data points assemble close to the mean and a high standard deviation means the data tend to spread out. For investors, standard deviation provides analysis of the volatility associated with an investment.
Click here to launch a portfolio standard deviation calculator.
Limitations of the Sharpe Ratio
While most analysts agree that the Sharpe Ratio is a useful tool for comparing portfolios or investment opportunities, some believe that standard deviation provides only a rough approximation of risk. It should also be notes that historical investment performance does not guarantee future results.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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