What is the Sharpe ratio? How investors use it to analyze an asset's risk

• The Sharpe ratio is a financial metric that shows how an investment is performing relative to its risk.
• The higher an investment's risk ratio is, the more returns it offers relative to its risks.
• The ratio is not useful to short-term traders since it is designed to analyze only long-term investments.

Any investment you make is going to come with some sort of risk. It's natural to wonder how much your investment will really benefit you. Even before you dive into a new venture, you'll want to know whether the time and money you put in will be worthwhile in the end.

This is where the Sharpe ratio comes in handy. Measuring investment returns and risk, the calculation is widely used among professional investment managers. Still, it's important to understand the Sharpe ratio and what it can teach you about your own money.

What is the Sharpe ratio?

The Sharpe ratio is a risk ratio that calculates an investment's average returns compared to its potential risks. It is calculated by subtracting the risk-free rate - such as that of a US Treasury bond - from the expected rate of return of the portfolio, and dividing the result by the standard deviation, otherwise known as the statistical measure of the asset's volatility.

The Sharpe ratio helps you see whether the risk you've taken on has paid off in your returns, compared to the returns you might have seen without taking on risk.

The Sharpe ratio was developed by William F. Sharpe in 1966 as an investment performance analysis tool. In 1990, Sharpe won the Nobel Prize in Economic Sciences.

Quick tip: The Sharpe ratio is important to understand because it provides a quick analysis for how your investment risk is paying off based on your returns.

Understanding how the Sharpe ratio works

The Sharpe ratio is a measurement that gives investors insights into investments' performances. The ratio analyzes performance over the long term, with the goal of helping investors figure out how to get a return that may not be the greatest possible, but is still good enough when downturns arise.

The Sharpe ratio is largely used by hedge funds and investment managers, rather than everyday investors, since they manage large portfolios and want to maximize customers' returns without too much volatility.

Quick tip: You may not have to calculate the Sharpe ratio yourself. Your brokerage may provide it for you in your account documents, or you can ask your investment manager about it.

Generally, the higher Sharpe ratio, the better. A high Sharpe ratio means that the risk is paying off in the form of above-average returns. However, a Sharpe ratio greater than zero is typically considered good. A zero Sharpe ratio means that your returns are matching the "risk-free" version of your investment, typically a Treasury security. While that's not necessarily bad, you also don't want to be taking on risk just to match that benchmark.

• Under 1.0 is considered bad
• 1.0 is considered acceptable or good
• 2.0 or higher is rated as very good
• 3.0 or higher is considered excellent

One way to increase your Sharpe ratio is to have a diversified portfolio. A main concept of modern portfolio theory, diversification and asset allocation ensure slow steady growth over time and help your portfolio weather the ups and downs of the markets.

How the Sharpe ratio is calculated

To calculate the Sharpe ratio, you first need your portfolio's rate of return.

Next, you need the rate of a risk-free investment, such as Treasury bonds. Subtract this risk-free rate from your portfolio's rate of return to find the excess return, or what your investment gives you above the Treasury bond.

Finally, you divide the difference of those two components by the standard deviation of the portfolio's excess return.

Here's what the equation looks like:

Return of portfolio: This is what your portfolio has earned, or what you expect to earn, over a given amount of time as a percentage of what you have invested.

Risk-free rate: This figure acts as your benchmark, or what you would've earned without virtually any risk. The Sharpe ratio often uses Treasury securities here because of their unlikeliness to default. For example, you might use a 5-year Treasury note rate to calculate the Sharpe ratio for your 5-year portfolio.

Standard deviation: This measurement of volatility indicates how much a return fluctuates over a period of time. Expressed as a positive number, the standard deviation accounts for both downside and upside changes.

"The impetus behind the ratio is taking standard deviation and volatility to find a simple numerical value," says Frederick.

Volatility is often understood as a bad thing, Frederick points out. But really, volatility means you're seeing price upsides along with downsides over time. The Sharpe ratio takes these factors and spits out a number that can tell you how your investments are doing relative to the risk.

Example of using the Sharpe ratio

Let's say you have an ETF with a 5-year, 30% return (R_p = 30).

Meanwhile, the 5-year Treasury has a rate of 0.83% (R_f = 0.83).

In this example, let's assume the standard deviation is 20% (σ_p = 20).

Now we can fill out the Sharpe ratio calculation.

Sharpe ratio = (30 - 0.83) ÷ 20

Sharpe ratio = 29.17 ÷ 20

Sharpe ratio = 1.46

With a solid Sharpe ratio of 1.46, you know the volatility your ETF weathers is being more than offset by your additional return.

Sharpe ratio vs. Sortino ratio

The Sortino ratio, created by Frank A. Sortino, is a relative of the Sharpe ratio that accounts more for downside risk.

In its calculation, the Sortino ratio still uses a risk-free rate, but subtracts that from the portfolio's average rate of return rather than the known or expected rate of return. It then divides the return difference by the standard deviation of the downside, not the general standard deviation.

The idea behind the Sortino ratio is that it provides a more real look at the risk being taken on since it doesn't account for the upside of volatility, which actually benefits the portfolio.

Limitations of the Sharpe ratio

The Sharpe ratio is not particularly useful for short-term traders, as it was designed to analyze long-term investments. Using the Sharpe ratio to manage your investments in the short term may even lead you to be more optimistic than you should be.

For example, let's say you use the Sharpe ratio using numbers around a three-year investment. If you only end up holding your investment for a year, that ratio won't really apply to your investment anymore. You may even end up operating at a loss depending on when you buy and sell.

Quick tip: Don't use the Sharpe ratio if you plan to trade investments within a year. The calculation is built for longer-term investments and may mislead your short-term investment strategy.

The financial takeaway

The Sharpe ratio is an important tool to understanding your investments. It takes into account your returns and your risk, and shows you whether your returns are worth the level of risk you're taking on.

If your Sharpe ratio is below 1, you'll know that while you're performing better than the benchmark, there is still some improvement to be made with your investments. Diversifying your portfolio can help drive that ratio up by buffering your investments against downturns.

Calculating a portfolio's Sharpe ratio doesn't have to be left up to professional investment managers. Everyday investors can calculate the ratio and turn to their brokerage to better understand what the ratio means for their portfolio.