Sharpe Ratio

In portfolio management, risk and reward is the tricky balance. Enter the Sharpe ratio, a tool to help investors measure the efficiency of a portfolio by measuring its risk adjusted returns. This post will dive into the Sharpe ratio, what it is, how it’s calculated and how to use it to make smart investment decisions.

The Sharpe Ratio

The Sharpe ratio is named after Nobel prize winner William F. Sharpe. It measures the extra return you get for taking on more risk. In other words it tells you how much extra profit you get for holding a riskier asset with higher volatility versus a risk free investment. This is the basic principle of finance: investors expect to be paid for taking on more risk.

Sharpe Ratio: A Foundation of Portfolio Management

The Sharpe ratio is one of the three ratios in portfolio management. It’s a way to standardize the risk adjusted performance of different portfolios. By looking at the Sharpe ratio you can get:

• Portfolio Efficiency: A higher Sharpe ratio means a more efficient portfolio, better returns for the risk taken.
• Risk-Return Trade Off: The ratio shows the trade off between risk and reward. More return comes with more volatility.

How to Calculate the Sharpe Ratio

Now that you know the formula you can calculate the Sharpe ratio for your own portfolio:

Sharpe Ratio = (Rp – Rf) / σp

Here’s what the variables mean:

• Rp: The average return of your portfolio over a certain period.
• Rf: The risk free rate of return, usually the interest rate on government bonds.
• σp: The standard deviation of your portfolio’s excess return, a measure of volatility.

Example

• You’re considering investing in ABC Corp Plc stock.
• Over the past 5 years the stock has returned 20% per annum.
• The risk free option is a UK Treasury Bill with an interest rate of 0.4%.
• The standard deviation of ABC Plc’s returns (volatility) is 15%.

Now plug in the numbers:

Sharpe Ratio = 20% – 0.4% / 15% = 0.784

Sharpe Ratio: A Guide

There’s no one size fits all, but generally a higher Sharpe ratio means a better portfolio for risk adjusted returns. Here’s a rough guide to Sharpe ratios:

• Below 1: Not enough return for the risk.
• 1-2: Moderate risk adjusted returns.
• Above 2: Strong risk adjusted performance.

What the Sharpe Ratio means to you:

• Risk-Taking Rewards: By subtracting the risk free rate from the average return, the Sharpe ratio isolates the returns from taking risk.
• Risk-Return Alignment: The ratio helps you see if a portfolio matches your risk tolerance and return expectations.

Beyond the Basics: Considerations and Caveats

While the Sharpe ratio is useful we need to remember:

• Historical Data: It’s based on past performance which may not be forward looking.
• Single Risk Measure: Volatility (measured by standard deviation) is just one type of risk. Market crashes or liquidity issues may not be captured.
• Limited Comparability: The Sharpe ratio is best used when comparing portfolios with the same asset classes and time horizon.

Sharpe Ratio vs. Other Risk-Adjusted Ratios:

The Sharpe ratio is popular but not the only risk adjusted return metric. Here’s a comparison with two others:

• Treynor Ratio: This ratio looks at the extra return per unit of systematic risk (market risk) rather than total risk. Useful when comparing portfolios with similar market risk.
• Sortino Ratio: This ratio penalizes downside volatility, rewards for taking on positive risk. Useful for investors who hate downside.

Sharpe Ratio and Portfolio Optimization:

Portfolio optimization methods aim to create a portfolio that gets you the return you want for the risk you want. The Sharpe ratio can be used with these methods. One popular portfolio optimization method is Modern Portfolio Theory (MPT). MPT uses expected returns and standard deviations of individual assets to create an efficient frontier, a set of portfolios with the highest return for a given risk. The Sharpe ratio can be used with MPT to find the portfolios on the efficient frontier that have the best risk adjusted returns.

Here’s how to use the Sharpe ratio in portfolio optimization:

• Ranking Portfolios: Calculate the Sharpe ratio for each portfolio on the efficient frontier and pick the one with the highest risk adjusted return.
• Customizing for Risk Tolerance: If you are more risk tolerant you can target the portfolio with the highest Sharpe ratio on the frontier, if you are more risk averse you can go for the one with slightly lower Sharpe ratio but more conservative risk profile.

Sharpe Ratio and Real-World

While the Sharpe ratio is useful don’t forget to consider it in the context of your overall strategy. Here are some real-world applications:

• Performance Measurement: Use the Sharpe ratio to measure the historical performance of your portfolio against a benchmark or another portfolio. If your Sharpe ratio is consistently higher than the benchmark or another portfolio you might be getting better risk adjusted returns.
• Active vs. Passive: The Sharpe ratio can be used when comparing actively managed funds to passively managed index funds. Actively managed funds try to beat the market, and a higher Sharpe ratio than the benchmark index might mean active management is working.

But remember in real life:

• Estimation Errors: estimating future returns and volatility is hard, will get the Sharpe ratio wrong.
• Non Normal Returns: Sharpe ratio assumes normal distribution of returns which may not always be true in markets. This will affect the ratio.
• Transaction Costs: buying and selling costs will eat into returns and are not included in the Sharpe ratio.

CONCLUSION

The Sharpe ratio is a tool for investors to measure the risk adjusted performance of their portfolio. Use it with others and you get the full picture. Remember the Sharpe ratio is a guide not the answer. Use it with your risk tolerance, investment goals and a diversified portfolio to invest with more conviction.