Sharpe Ratio
The Sharpe ratio is a risk-adjusted return measure that calculates the excess return earned per unit of total risk (standard deviation), helping investors compare the efficiency of different investments or portfolios.
Exam Tip
Sharpe = excess return / standard deviation (TOTAL risk). Higher = better. Use Sharpe for entire portfolio evaluation. Use Treynor for individual fund evaluation (uses beta). Sortino uses downside deviation only.
What is the Sharpe Ratio?
The Sharpe ratio, developed by Nobel laureate William Sharpe, measures how much excess return (above the risk-free rate) an investment generates for each unit of total risk taken. A higher Sharpe ratio indicates better risk-adjusted performance.
Formula
Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation
Interpreting the Sharpe Ratio
| Sharpe Ratio | Interpretation |
|---|---|
| < 0 | Investment underperformed the risk-free rate |
| 0 - 1.0 | Suboptimal risk-adjusted return |
| 1.0 - 2.0 | Good risk-adjusted return |
| 2.0 - 3.0 | Very good risk-adjusted return |
| > 3.0 | Excellent (rare in practice) |
Example Calculation
| Component | Value |
|---|---|
| Portfolio Return | 12% |
| Risk-Free Rate | 4% |
| Standard Deviation | 16% |
| Sharpe Ratio | (12% - 4%) / 16% = 0.50 |
Sharpe vs. Other Risk Measures
| Measure | Risk Used | Best For |
|---|---|---|
| Sharpe Ratio | Total risk (std. deviation) | Undiversified portfolios |
| Treynor Ratio | Systematic risk (beta) | Diversified portfolios |
| Jensen's Alpha | Expected return (CAPM) | Manager evaluation |
| Sortino Ratio | Downside deviation | Downside-focused analysis |
Limitations
- Uses standard deviation (assumes normal distribution)
- Backward-looking (past performance)
- Can be manipulated by time period selection
- Does not distinguish upside vs. downside volatility
Exam Alert
Sharpe ratio uses TOTAL risk (standard deviation), not just systematic risk. Higher = better. Compare to Treynor ratio which uses BETA (systematic risk only). Sharpe is best for evaluating an investor's ENTIRE portfolio. Treynor is better for evaluating a single fund within a diversified portfolio.
Study This Term In
Related Terms
Beta
Beta is a measure of a security's volatility relative to the overall market, where a beta of 1.0 means the security moves with the market, above 1.0 means more volatile, and below 1.0 means less volatile.
Modern Portfolio Theory (MPT)
MPT is Markowitz's 1952 framework for constructing portfolios to maximize expected return for a given risk level through diversification.
Diversification
Diversification is an investment strategy that spreads investments across various assets, sectors, or geographic regions to reduce risk without necessarily sacrificing returns.
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