Sharpe ratio
The Sharpe ratio measures how much return an investment earned for each unit of risk it took. It subtracts a benchmark rate for holding safer instruments from the return, then divides by volatility. A higher figure means more return for the risk.
The formula
Sharpe ratio = (Return minus Risk-free rate) divided by Volatility. The risk-free rate is a benchmark for a safer instrument, such as a government security. Volatility is how much the returns swung, usually measured as the standard deviation of returns.
Why it is used
Return alone means little until it is weighed against what was risked to earn it. Two funds can show the same return, but one may have got there with wild swings and the other smoothly. The Sharpe ratio puts both on the same scale so they can be compared.
How to read it
A higher Sharpe ratio means more return per unit of risk. There is no single number that is good in every setting, so it is best used to compare similar funds over the same period, not as a verdict on its own.
Where it falls short
The ratio uses past data, so it cannot tell you what a fund will do next. It changes with the period and the benchmark rate chosen. It also treats all swings alike, including upward ones, and it can understate rare, large losses. Other measures, such as the Sortino ratio, weigh risk differently.
Comparing two funds (hypothetical numbers)
Suppose the risk-free rate is 6 percent. Fund A returned 12 percent with volatility of 10 percent, so its Sharpe ratio is (12 minus 6) divided by 10, which is 0.6. Fund B returned 15 percent with volatility of 20 percent, so its ratio is (15 minus 6) divided by 20, which is 0.45. Fund B earned more, but Fund A earned more for each unit of risk.
Common questions
- What does the Sharpe ratio measure?
- The return earned for each unit of risk taken.
- What is the Sharpe ratio formula?
- (Return minus risk-free rate) divided by volatility.
- Is a higher Sharpe ratio always better?
- It shows more return per unit of risk in the past, but it does not predict the future and depends on the period and benchmark used.
- What is the risk-free rate?
- A benchmark return on a safer instrument, such as a government security, used as the starting point.