The Sharpe ratio, named after its creator, William F. Sharpe, is a way to look at how the risks of an investment compare to its potential rewards.
Learn how to find the Sharpe ratio and how you can use it to compare investment products.
What Is the Sharpe Ratio?
The Sharpe ratio measures the reward-to-variability rate of an investment by dividing the average risk-adjusted return by volatility. People can compare investments and assess the amount of risk that each one has per percentage point of return. This helps people better control their risk exposure. The higher the rate, the more returns the investment offers, relative to the risks involved.
The Sharpe ratio was introduced by Stanford economist William F. Sharpe in 1966.
How Do You Find the Sharpe Ratio?
To find the Sharpe ratio for an investment, you first subtract the risk-free rate of return (like a Treasury bond return) from the expected rate of return of the investment. Then, divide that figure by the standard deviation of that investment's annual rate of return, which is a way to measure volatility.
How Does the Sharpe Ratio Work?
To better see how the Sharpe ratio works, it might help to review volatility measurements and risk-adjusted returns.
Risk-Adjusted Returns 101
The most common way to measure risk is using the beta coefficient. It measures a stock or fund’s volatility against a benchmark like the S&P 500 index. If a stock has a beta of 1.1, you can expect it to be 10% more volatile than the S&P 500 index. A 30% increase in the S&P 500, for instance, should result in a 33% increase in the stock or fund with the 1.1 beta. When 30% is multiplied by 1.1, you get 33%.
Beta coefficients can be used to find an investment’s alpha. The alpha is a risk-adjusted return that accounts for risk. Alpha is found 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% when the S&P 500 goes up by 30% would bring an alpha of 5%. This assumes a risk-free rate of 2% (40% – 33% – 2% = 5%), which is a 5% risk-adjusted return.
It’s vital to note that investments with a higher beta must create a higher total return to see a positive alpha. For instance, a stock with a beta of 1.1 would need to see 10% greater returns than the S&P 500 index plus the risk-free rate to create a neutral alpha. As a result, safer stocks can bring higher risk-adjusted returns even if they produce lower total returns since they entail less risk of loss over the long run.
The problem with beta coefficients is that they are relative rather than absolute. By finding the rate of return per unit of volatility, you have a better sense of how the risk compares to the reward.
When you invest, you should always look at risk-adjusted returns when choosing where to invest your money. Not taking a clear look at risk can prove costly over the long run. While beta and alpha are good ways to do so, you may want to try using the Sharpe ratio instead, given its use of absolute rather than relative measures of risk. These metrics can be much more helpful when choosing investments.
Limits of the Sharpe Ratio
It's vital to only compare very similar investments with the Sharpe ratio. Otherwise, it won't be as helpful. The Sharpe ratio is great for looking at mutual funds or ETFs that track the same underlying index. It doesn't work nearly as well for comparing stocks. This is even more true if there are major contrasts between the companies being looked at.
While the Sharpe ratio makes for a fairer comparison between similar investments, you should keep in mind that those with a higher Sharpe ratio can be more volatile than those with a lower rate. The higher Sharpe ratio simply shows that the investment’s risk-to-reward profile is more optimal or proportional than another. There could still be big risks.
It’s also vital to note that a Sharpe ratio isn’t viewed on any kind of scale, which means that it’s only helpful when comparing options.
- The Sharpe ratio is a rate that compares an investment's returns to its risk.
- Finding the Sharpe ratio involves subtracting the risk-free rate of return from the expected rate of return, then dividing that result by the standard deviation, otherwise known as the asset's volatility.
- The Sharpe ratio is named after the creator, William F. Sharpe, who first introduced it in the mid-'60s.