Why Every Investor Needs to Know About Sharpe Ratio

Key Takeaways

• The Sharpe ratio basically allows investors to assess an investment’s risk-adjusted returns.

• In terms of risk-adjusted returns, the higher the ratio, the better the investment.

• A Sharpe ratio limitation is that normal distributions do not reflect how financial markets actually operate, in that investment returns – at least over the short term – are not normally distributed due to market volatility.

Investors that seek to maximize returns and minimize risk would do well to understand the Sharpe ratio, which helps investors assess an investment’s return relative to the risk involved. The tool’s calculation may be based on forecast or historical returns. But what is the Sharpe ratio? Here is that and more.

What is Sharpe Ratio?

Named for economist William Sharpe, the Sharpe ratio has to do with risk-adjusted returns. It is a way to gauge an investment’s performance that folds in risk – specifically, the additional risk necessary for higher returns. Thus, the ratio allows investors to assess an investment’s risk-adjusted returns.

While investments can be evaluated exclusively relative to their projected returns, investors get a better understanding of their investment when they understand the level of risk they have taken or are about to take.

Also known as the Sharpe index, the ratio can be utilized to assess a single security or an entire investment portfolio. Either way, in terms of risk-adjusted returns, the higher the ratio, the better the investment.

By sizing up an investment’s expected return to the additional risk – relative to a minimally risky asset such as U.S. Treasury securities – the Sharpe ratio provides investors with a clear view of whether loftier returns are sufficiently rewarding them for assuming such extra risk.

How Does the Sharpe Ratio Work?

Investors generally aim for two objectives that are often at odds: the highest returns possible and minimal risk.  Where the Sharpe ratio can help is apprising the investor of their risk-adjusted returns.

Whether it is employed to measure past performance or anticipated future performance, the ratio can help investors learn about their returns: are they due to savvy decisions or from assuming excessive debt? If they are due to too much debt, investors could lose uncomfortable amounts when market conditions change.

The Sharpe ratio helps by providing investors with a numeral that tells them their risk-adjusted returns.  

How is Sharpe Ratio Calculated?

The Sharpe ratio is calculated by subtracted the risk-free rate from the holdings’ rate of return, frequently utilizing U.S. Treasury bond returns as a proxy for the risk-free return rate. Subsequently, the result is divided by the standard deviation of the portfolio’s excess return.

Sharpe Ratio = Rp – Rf

 ———-

Standard Deviation of the portfolio’s Excess Returns (x) 

where:

• Rp is the expected return on whatever asset or portfolio is being measured
• Rf is the risk-free rate, which is commonly a U.S. Treasury bill that is short of maturity. However, some financial experts contend that the Treasury that is used should be of similar duration.
• Standard deviation (x) is an assessment of risk that is based on volatility. All things being equal, the lower the standard deviation, the less risk that is involved and the lower the Sharpe ratio.
• The market risk premium is part of the formula that is represented by Rp-Rf and is the excess return above the risk-free rate. 

The ratio should provide investors with an unambiguous picture of risk versus return, demonstrating the amount of return is gained from the extra risk. Relative to the risk taken on a security or portfolio, the higher the ratio, the greater the investment return.

For example, portfolio A is expected to return 14% over the next year, while portfolio B, over the same period, is expected to return 11%. Without factoring in risk, portfolio A is obviously the best option.

The picture looks a bit different when risk is considered, as the Sharpe ratio provides a more comprehensive look at investments. Here, portfolio A presents an 8% standard deviation (additional risk) while portfolio B’s standard deviation is just 4%. Meanwhile, the risk-free rate is 3%, which is the yield for a medium-term U.S. Treasury security.

Here, then, is the Sharpe ratio for each portfolio:

1. Portfolio A: (14 – 3) / 8 = 1.38
2. Portfolio B: (11 – 3) / 4 = 2

So, after factoring in the volatility inherent in portfolio A, the Sharpe ratio of those holdings is less than portfolio B’s ratio. This means that, with a ratio of 2, portfolio B offers the best return on a risk-adjusted basis.

In general, financial experts consider a Sharpe ratio of two as good, while one that is between two and three is very good. A result over three is deemed excellent.

Components of the Sharpe Ratio

The major components of the Sharpe ratio include:

• Return. In the calculation, return is the amount an asset yields. If normally distributed, the measured returns can be daily, weekly, monthly, or yearly. An issue here is that not all asset returns are normally distributed.
• Risk-free rate. The risk-free rate employed in the Sharpe ratio’s calculation is usually either U.S. Treasury bills or the rate for cash. It is used to gauge whether the investor is appropriately compensated for the extra risk assumed. Note that while the T-bill has the least volatility, some contend that the security should equal the comparable investment’s duration.
• Standard deviation. Standard deviation is an assessment of the variability of an investment return as it relates to the investment’s mean return for the time period being measured. It reveals an investment return’s volatility relative to its average return, with larger standard deviations indicating wider returns, and narrower standard deviations suggesting more concentrated returns.

Understanding Risk-Adjusted Return

Part of understanding risk-adjusted return means considering return and risk together and assessing investment performance.

The risk-adjusted return gauges the amount of profit an investment has made relative to how much risk the investment has represented during a certain time period. If multiple investments produced the same return over that period, the one with the lowest risk will generally have a better risk-adjusted return.

Interpreting Sharpe Ratio

The main point here is that a higher Sharpe ratio equals better risk-adjusted performance.  On the other hand, a negative Sharpe ratio signifies that the benchmark or risk-free rate exceeds the portfolio’s projected or historical return. If this is the case, the portfolio’s return is expected to be negative.

Limitations and Considerations

In investing, there is no perfect tool, and that includes the Sharpe ratio. Limitations and considerations include assumptions of normal distribution of returns, which are incorrect. The ratio assumes that returns are distributed normally on a curve. In such a distribution, the majority of returns are lumped around the mean and fewer returns are discovered in the curve’s tail.

The rub is that normal distributions do not reflect how financial markets actually operate, in that investment returns – at least over the short term – are not normally distributed due to market volatility. The result is a standard of deviation that is not as effective as a gauge of risk.

There is also an issue having to do with leverage, which is debt taken on to heighten an investment’s prospective return. Employing leverage raises an investment’s risk level. A substantial increase in standard deviation will result in a significant decline in the Sharpe ratio, and consequently, bigger losses.

Another consideration is that the Sharpe ratio is sensitive to the time period it is taken. In other words, it is not independent of the time period over which it is evaluated. Returns for multiple periods are typically computed by factoring in compounding, which renders the relationship more complex. 

For periods longer than a year, it is common to annualize data before computing a Sharpe ratio. In turn, this can provide helpful comparisons among strategies, even if forecasts are originally stated in terms of differing measurement periods.

Also, note that because the Sharpe ratio is crafted to analyze investments over the long term, it is not particularly useful to short-term traders.

Calculating Sharpe Ratio in Alternative Investments

Beyond securities such as stocks and bonds, investors can use Sharpe ratio to evaluate the risk-adjusted performance of investments or strategies in alternative investments – those with low correlation to public markets.

These investments, which include asset classes such as real estate, art, and structured notes, can potentially offer steady passive income, a hedge against inflation, and lower volatility. Such investments can also serve to diversify investment holdings. Crafting a portfolio with varying assets that have different expected risks and returns is a critical element of long-term successful investing. 

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

Despite its limitations, the Sharpe ratio can give investors a clearer view of risk for large, liquid, and diversified investments. In other words, it can come in handy in terms of measuring invest returns and risk. For some other investments, such as hedge funds, it is recommended that the ratio be used along with other risk-and-return tools.

Note that the metric can also be used with alternative investments, which also serve to diversify holdings, which can mitigate over portfolio risk.