Using the Sharpe Ratio to Measure Risk-Adjusted Returns
When evaluating an investment, most investors look at total returns over various timeframes, such as one year, three years, and five years. These returns can be a bit misleading since they aren’t adjusted for risk. After all, a penny stock may have risen over 100 percent over the past year, but that doesn’t necessarily make it a compelling investment opportunity.
The Sharpe Ratio can help investors compare investments in terms of both risks and return.
Risk-Adjusted Returns 101
The most common way to measure risk is using the beta coefficient, which measures a stock or fund’s volatility relative to a benchmark like the S&P 500 index. If a stock has a beta of 1.1, investors can expect it to be 10 percent more volatile than the S&P 500 index. A 30-percent increase in the S&P 500, for example, should result in a 33-percent increase in the stock or fund with the 1.1 beta (and vice versa for a decline) since 30 percent times 1.1 equals 33 percent.
Beta coefficients can be used to calculate an investment’s alpha, which is a risk-adjusted return that accounts for risk. Alpha is calculated by subtracting an equity’s expected return based on its beta coefficient and the risk-free rate by its total return. A stock with a 1.1 beta coefficient that increases 40 percent when the S&P 500 increases 30 percent would generate an alpha of 5 percent assuming a risk-free rate of 2 percent (40 percent - 33 percent - 2 percent = 5 percent) – a 5 percent risk-adjusted return.
It’s important to note that investments with a higher beta must generate a higher total return to see a positive alpha. For example, a stock with a beta of 1.1 would need to generate 10 percent greater returns than the S&P 500 index plus the risk-free rate to generate a neutral alpha. Therefore, safer stocks can generate higher risk-adjusted returns even if they produce lower total returns since they entail less risk of loss over the long run.
What Is the Sharpe Ratio?
The problem with beta coefficients is that they are relative rather than absolute. If an investment’s R-squared is too low, for example, then the beta coefficient isn’t meaningful and the alpha doesn’t matter. Alpha also doesn’t differentiate between stock-picking skill or luck when looking at an investment’s merits, which can make it difficult to use as a comparison tool for funds or individual investment opportunities.
The Sharpe ratio is a measure for calculating risk-adjusted returns that solves these issues by taking the average return earned above the risk-free rate per unit of volatility or total risk — an absolute measure of risk. Investors can directly compare multiple investments and evaluate the amount of risk that each manager took on to generate the same percentage points of return, which makes for a much fairer comparison.
While these attributes make for a fairer comparison, investors should keep in mind that investments with a higher Sharpe ratio can be more volatile than those with a lower ratio. The higher Sharpe ratio simply indicates that the investment’s risk-to-reward profile is more optimal or proportional than another. It’s also important to note that a Sharpe ratio isn’t expressed on any kind of scale, which means that it’s only helpful when comparing options.
The Bottom Line
Investors should always look at risk-adjusted returns when evaluating various opportunities, since ignoring risk can prove costly over the long run. While beta and alpha are good ways to do so, investors may want to consider using the Sharpe ratio instead, given its use of absolute rather than relative measures of risk. These metrics can be much more helpful when comparing different funds or stocks across different categories.
Investors may also want to consider other measures of risk-adjusted returns that can be helpful in specific situations. For example, the Treynor ratio uses a beta coefficient in place of standard deviations to take market performance into account, while Jensen’s Alpha uses the capital asset pricing model to determine how much alpha a portfolio is generating relative to the market. Investors should find the measure that best suits their individual needs.
There are also many ways to evaluate valuation between companies or funds. For example, the CAPE ratio offers an improved version of the price-earnings ratio that looks at cyclical behaviors rather than one-off multiples. It’s important to look beyond headline valuation metrics, as well as risk-adjusted return metrics, to identify promising investment opportunities.