What Is the Sharpe Ratio?
A Sharpe Ratio measures the performance of an asset relative to its volatility. It compares the returns of an asset against the returns of a benchmark index (such as the S&P 500) without considering any fees or costs associated with investing. This was developed by Nobel Prize-winning economist William F. Sharpe. This was widely seen as a new version of the CAPM. In general, a higher Sharpe Ratio indicates good risk-adjusted returns.
Sharpe Ratio Formula and Calculation
The Sharpe Ratio is a measure of the excess return (or risk-adjusted return) of an investment compared to a risk-free asset, such as a Treasury bill. It is calculated as the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Formula:
Sharpe Ratio = (Rp – Rf) / σp
Where:
Rp = the average return of the portfolio
Rf = the risk-free rate of return
σp = standard deviation of the portfolio’s excess returns
What are Some Sharpe Ratios for Large Companies?
As of 2020, here are the Sharpe Ratios for several large public companies:
1. Apple Inc. (AAPL) had a Sharpe Ratio of 0.31
2. Microsoft Corp. (MSFT) had a Sharpe Ratio of 0.53
3. JPMorgan Chase & Co. (JPM) had a Sharpe Ratio of 0.45
4. Amazon.com Inc. (AMZN) had a Sharpe Ratio of 0.89
What Does the Sharpe Ratio Tell?
The Sharpe Ratio is a measure of risk-adjusted performance. It compares an investment’s return relative to the risk-free rate of return, taking into account its volatility. The higher the Sharpe Ratio, the better the investment’s return is relative to its risk. This can help investors determine whether an investment is a good choice for their portfolio.
The relationship between risks and returns is an important concept in finance. It measures how much return people earn for every additional dollar they invest.
How to Use Sharpe Ratio
You use the Sharpe Ratio as a tool to measure the performance of an investment portfolio relative to its unit of risk.
It is calculated by taking the normal investment return of the portfolio and subtracting the risk-free rate of return. The next step is to divide by the standard deviation of the portfolio returns.
To use the strategy to weigh future performance, investors begin by calculating the returns of their portfolio over a certain period of time. One investment performance calculation to consider selecting is an annual return.
Using this initial calculation, the investor then determines the risk-free rate of return, which is typically the rate of return on a government bond or other equivalent investment. And finally, calculate the standard deviation of the portfolio returns.
Once these three values are determined, the Sharpe Ratio can compute asset returns by dividing the average return of the portfolio minus the risk-free rate of return by the standard deviation of the portfolio returns. The higher the Sharpe Ratio, the better the performance of the portfolio relative to its risk.
Benchmark of a Good Sharpe Ratio
In general, a higher Sharpe Ratio indicates a better risk-adjusted return. As a benchmark, a Sharpe Ratio of 1.0 or higher is considered good. While there is no definitive answer as to what represents a “good” Sharpe Ratio, a ratio of 1.5 or higher is generally considered to be excellent, and a ratio of 0.5 or lower is generally considered to be sub-par.
Shortcomings of The Sharpe Ratio
While the Sharpe Ratio is seen as a strong metric to compare investments, there are some shortcomings in using this. Some of those include:
1. It is not a measure of absolute performance. The Sharpe Ratio is a risk-adjusted measure of return and does not take into account the total return of an investment. For example, an investment that produces a higher Sharpe Ratio, but lower returns, is not necessarily a better investment.
2. It is not a measure of risk. The Sharpe Ratio does not measure the risk of an investment. It is a measure of the return on the risk taken but does not measure the actual risk taken. This can be a point of confusion for new investors.
3. It assumes a normal distribution of monthly returns. This formula assumes that the returns of investment follow a normal (or Gaussian) distribution. In reality, many investments do not follow such a distribution.
4. It does not account for all sources of risk. For example, it does not take into account the risk of default or the risk of a sudden market crash.
FAQ
What does Sharpe Ratio tell you?
The Sharpe ratio is a useful tool for investors to assess the performance of their portfolios relative to the amount of risk taken on. It also helps investors compare different opportunities and decide which one is the most attractive for investments with positive returns. Additionally, the Sharpe ratio can be used to identify potential areas of improvement in a portfolio. For example, if the Sharpe ratio of a portfolio is low, it may indicate that the portfolio is taking on too much risk for the returns it is generating.
What does a Sharpe Ratio of 0.5 mean?
A Sharpe ratio of 0.5 indicates that the return on the investment is approximately half the volatility or risk of the investment. This is considered a relatively low risk/reward ratio and may be suitable for conservative investors; however, it is not labeled as “good.”
Is a higher Sharpe Ratio better?
Yes, a higher Sharpe ratio generally indicates that an investment has a higher risk-adjusted return. The Sharpe ratio is a measure of risk-adjusted return, and investments with a higher Sharpe ratio are considered to be better investments because they offer higher returns for the same amount of risk.
When is the Sharpe Ratio wrong?
While no estimation formula should be relied on for 100% accuracy, studies show that the Sharpe Ratio is less accurate with hedge fund calculations.
