Investing is all about balancing risk against potential returns. For example, imagine you could invest $1,000 today and have a 50-50 chance of that investment growing 1% to $1,010, or it could go to zero. Would you invest? Of course not! Nobody in their right mind would risk a potential $1,000 loss for a $10 potential return on a coin flip.
There are several ways to determine the potential risk and potential reward of an investment. Many investors seek to find the intrinsic value of an investment by looking into the growth prospects of a company and comparing its valuation to others in its industry.
However, there is one metric that is especially popular for attempting to gauge risk-adjusted returns: the Sharpe ratio.
What Is the Sharpe Ratio?
The Sharpe ratio was developed by American economist and Nobel laureate William F. Sharpe. It was designed to give investors an easy-to-understand way to gauge the additional potential for profitability that’s gained by accepting additional risks. The ratio shows the average return rate of a portfolio minus risk-free returns.
What Does the Sharpe Ratio Measure?
The Sharpe ratio was developed to measure the risk-adjusted return of an investment or portfolio. Investment opportunities with a higher level of risk in relation to their potential returns have low Sharpe ratios, while these ratios will be high on investment opportunities that have a low level of risk in relation to their potential returns.
Investors use the Sharpe ratio when making investment decisions to determine whether potential returns are worth added risks.
What Is the Sharpe ratio Formula?
The formula for the Sharpe ratio is as follows:
(Rp – Rf) ÷ SdOp
- Rp — Return of Portfolio: The portfolio’s return is the rate of return the portfolio generates on an annual basis. The current Sharpe ratio accounts for the rate of return from the portfolio over the past year, while the forward-looking Sharpe ratio uses the expected return over the next year.
- Rf — Risk-Free Rate of Return: The risk-free rate of return is the return rate you can expect from a risk-free investment. Investors often use a one- or two-year U.S. Treasury yield as a benchmark for the risk-free rate of return.
- SdOp — Standard Deviation of Portfolio: This is a statistical measure of the portfolio’s returns in relation to the overall market, otherwise known as its rate of volatility.
How to Use the Sharpe Ratio
The best way to use the Sharpe ratio is when determining whether to add or remove investments from your portfolio. The Sharpe ratio can help you determine whether the moves will increase or decrease your expected returns relative to the change in risk. It is a useful way to tell how diversification into asset classes with a different risk-return profile impacts your overall risk-adjusted returns.
For example, let’s say your portfolio — a mix of stocks and bonds — yielded 14% returns over the past year. The current risk-free rate is 3.5% and your portfolio’s rate of volatility is 10%, meaning your portfolio’s Sharpe ratio is currently 1.05 or 105% — (14 – 3.5) ÷ 10.
Say you want to know if adding a riskier exchange-traded fund (ETF) and a hedge fund to your portfolio will result in a higher return on a risk-adjusted basis. Based on analyst projections, you believe that adding these assets to your portfolio would increase your annual return to 16% and your portfolio’s volatility to 10.5%.
Based on these numbers — (16 – 3.5) ÷ 10.5 — your new Sharpe ratio would be 1.14 or 114%. Because the move would cause your portfolio’s Sharpe ratio to increase by nine percentage points, it would be a strong move to improve your risk-adjusted return.
In other words, even though you’re taking on more risk in this example, the increased potential returns should be worth it, on average. By contrast, if adding some high-risk, high-return asset actually decreased your portfolio’s Sharpe ratio, you could conclude that the higher potential returns aren’t worth the added risk.
What Is a Good Sharpe Ratio?
The higher the Sharpe ratio, the better. Higher ratios mean that you’ll be rewarded with a larger potential gain for the risk you’re taking.
In general, Sharpe ratios of 1, 2, and 3 act as thresholds for good, great, and exceptional opportunities. Investments with Sharpe ratios over 3 suggest the best possible risk-adjusted return on the market.
What Does a Sharpe Ratio Below 1 Mean?
Any investment with a Sharpe ratio below 1 is a cause for concern, because it suggests the returns per unit of risk are below average. In other words, you’re taking on more risk for less potential return.
A Sharpe ratio of 0.5, or 50%, suggests that the investment comes with a high level of risk in relation to its return. In the past, a 0.5 ratio might have been considered decent, but due to prolonged low interest rates resulting in a lower risk-free rate today, a 0.5 ratio is no longer acceptable.
When an investment has a negative Sharpe ratio, it means that the investment is either expected to lose money over time or fail to produce returns equal to or above the risk-free rate. Essentially, when an asset has a negative Sharpe ratio, you’d be better off with risk-free U.S. Treasury debt securities.
Advantages and Disadvantages
As with any other metric that’s widely used by investors, the Sharpe ratio comes with its own list of pros and cons.
Advantages of Using the Sharpe Ratio
As an investor, there’s significant value in understanding the level of risk associated with an investment in relation to its return potential. Some of the biggest advantages of using the Sharpe ratio in your investing process include:
1. Avoid Undue Risk
Making significant returns in the market will always come with some level of risk. The name of the game is balancing the amount of risk you accept with the potential return you’re expecting to generate.
That’s exactly what the Sharpe ratio does. It helps investors determine if risk and return are in balance with an easy-to-understand scoring scale.
2. Make Comparisons Across Different Investment Types
Wall Street experts will often tell you that you can’t compare apples to oranges, and stocks or other assets should only be compared to others in their category.
With the Sharpe ratio, it’s possible to compare stocks across different sectors or even completely different assets from a risk-adjusted return perspective.
3. Simplicity of the Formula
Some metrics are so complex that investors would rather use online tools — often paid tools — than trying to work out the calculations themselves. The Sharpe ratio is a relatively simple, straight-forward formula that even beginners will easily understand with a little practice.
Disadvantages of Using the Sharpe Ratio
Sure, there are plenty of reasons to use the Sharpe ratio in your investing process, but there are also some significant drawbacks to consider.
1. Potentially Unreliable Results
The formula has its limitations. You see, with the portfolio’s overall standard deviation as part of the denominator, the Sharpe ratio suggests that volatility is equal across each asset within your portfolio. With a large number of surprising drops and gains in prices of individual assets taking place in the markets all the time, some argue that the formula is unreliable.
After all, each individual asset you hold will have a different level of volatility, and the ratio provides no information on an asset-by-asset basis — the type of information you may need when adjusting your portfolio.
2. Can Be Manipulated by Portfolio Managers
Another issue some have with the Sharpe ratio is that portfolio managers can manipulate the ratio to make it look like they’re producing better results than they actually are. This is done by lengthening the measurement interval, since volatility naturally does some leveling out over time.
The annualized standard deviation of daily returns will just about always be higher than that of weekly returns, and weekly return deviations will be higher than monthly. By producing reports with annualized standard deviations averaged over longer periods of time, portfolio managers can make it look like there’s less risk in your portfolio than there actually is.
Frequently Asked Questions
As with any other commonly used investing metric, there are a few common questions surrounding the Sharpe ratio. Some of the most common include:
What Is the Sharpe Ratio of the S&P 500?
The S&P 500 index currently has a Sharpe ratio of 2.81 or 281%. However, many argue that the ratio is skewed to the upside thanks to a strong recovery from the COVID-19 pandemic and a prolonged low interest rate resulting in a low risk-free return.
What Is the Sharpe Ratio of the NASDAQ Composite Index?
The NASDAQ Composite Index currently has a Sharpe ratio of 2.13 or 213%. Again, many believe the ratio is skewed to the upside for the same reasons as with the S&P 500.
What Is a Good Sharpe Ratio for a Mutual Fund?
Whether you’re considering investing in a mutual fund, ETF, or other investment-grade portfolio fund, the general Sharpe ratio range is a great rule of thumb to follow, with a ratio of 1 to 1.99 being acceptable, 2 to 2.99 being great, and 3 or above being exceptional.
How Can I Improve the Sharpe Ratio of My Portfolio?
Increasing the Sharpe ratio in your portfolio is as easy as focusing your investments on assets that are known for producing the most worthwhile risk premiums.
For example, according to Businesswire, the three top sectors by Sharpe ratio are technology, utilities, and health care. By adding well-researched investments from these sectors to your portfolio, it’s likely that you’ll increase your Sharpe ratio.
Paying close attention to risk-adjusted returns will help you keep your portfolio in line with your goals, both in terms of growth and risk management. The Sharpe ratio is one of the most widely accepted tools for doing just that.
However, when using the ratio, it’s important to keep in mind that there are some drawbacks. Making adjustments, like using the Sharpe ratio in conjunction with the Sortino and Treynor ratios, will give you a better overall picture of what to expect on a risk-adjusted basis.
Nonetheless, the use of one or all of the variations of the Sharpe ratio are great additions to your investment research process.