Understanding Sharpe Ratio with Examples

Sharpe ratio is amongst the most popular metrics used to measure the attractiveness of any investment. This ratio can help any investor understand the risk-adjusted return on the investment. Through this blog, let’s understand the meaning of sharpe ratio in detail and how it can affect your investment decision.

What is Sharpe Ratio?

Sharpe ratio, also known as sharpe index, is a metric used to provide the risk- adjusted return of any investment. The Sharpe ratio is a measure of risk-adjusted return that shows how much excess return an investment generates for the level of risk taken.

To calculate the Sharpe ratio, you need to subtract the risk-free rate of return (what you could earn from a risk-free investment, like government bonds) from the return of the fund or portfolio. This difference is called the “excess return.” Then, you divide the excess return by the standard deviation of the fund’s returns, which represents the risk or volatility of the investment.

A higher Sharpe ratio indicates better risk-adjusted performance, meaning the investment provides more return for each unit of risk taken.

This ratio helps investors by providing a bigger picture whether the returns of any investment are compensating the additional risk they are willing to pay

Sharpe Ratio Formula

By using this simple formula, sharpe ratio of any investment can be calculated:

Sharpe Ratio Formula= (R(p)-R(f))/SD

• R(p): It refers to the historic refunds of funds for which you wish to calculate the sharpe ratio. Returns from a longer time period provide better results.
• R(f): It stands for risk-free return. For example- Return of a 365 day treasury bill, etc. Any return will provide the results.
• SD: It refers to the standard deviation of a fund’s return. It indicates the volatility or fluctuations in returns. The higher the fluctuation the higher is risk.

Sharpe Ratio: Example

Suppose you have invested in a mutual fund that has provided an average annual return of 10% over the last year. During the same period, the risk-free rate (e.g., return on government bonds) was 3%. The standard deviation of the mutual fund’s returns (a measure of volatility or risk) is 8%.

Step-by-step calculation:

1. Calculate the Excess Return:

– Excess return is the difference between the return of the fund and the risk-free rate.

– Excess return = 10% (return of the fund) – 3% (risk-free rate) = 7%.

2. Determine the Standard Deviation (SD) of the Fund’s Returns:

– In this example, the standard deviation of the mutual fund’s returns is given as 8%.

3. Calculate the Sharpe Ratio:

– Sharpe Ratio = Excess Return / Standard Deviation

– Sharpe Ratio = 7% / 8% = 0.875

• A **Sharpe ratio of 0.875** means that for every unit of risk (as measured by the standard deviation of returns), the mutual fund provides an excess return of 0.875.
• Generally, a higher Sharpe ratio indicates a better risk-adjusted return. A ratio above 1 is considered good, above 2 is very good, and above 3 is excellent. In this example, a Sharpe ratio of 0.875 suggests that while the mutual fund is providing some return over the risk-free rate, it may not be the most efficient use of risk from a risk-adjusted perspective.

Sharpe Ratio Classification

To answer the question ‘What is a good sharpe ratio‘, below is the table that provides the classification of sharpe ratio based on a parameter.

Remember, higher the sharpe ratio, higher is the risk on that investment

Importance of Sharpe Ratio

Following are a few points that shows the significance of sharpe ratio and how does it helps investor in decision making:

• Calculated risk-adjusted return: The most important role of sharpe ratio is to provide investor information about risk-adjusted returns on their investment. It shows the risk that is associated with any investment and helps the investor make an informed decision.
• Comparison against benchmark: If an investor has already invested in a fund, they can also use sharpe ratio to compare the existing fund with peer funds.
• Promotes fund comparison: Sharpe ratio can be compared with various mutual funds to know the risk associated and adjusted-return rates.
• Promotes portfolio diversification: Sharpe ratio helps assess whether you need to diversify your portfolio. For example- If your current investment has a high Sharpe ratio, it indicates strong risk-adjusted returns. To further balance your portfolio, you can consider adding investments with different risk profiles. This can help reduce overall risk and improve your returns.
• Evaluates fund performance: Sharpe ratio helps investors in understanding the performance of your investment. The investors get a chance to compare their risks with the returns by the investment.

What are the Limitations of Sharpe Ratio?

• The Sharpe ratio uses standard deviation to measure risk, which includes both positive and negative fluctuations. This means a high standard deviation can lower the Sharpe ratio, making a fund seem riskier than it is, even if its positive returns are substantial.
• Sharpe ratio considers the disruption of pattern normal for every investment, whereas it may vary from one investment to another.

The Sharpe ratio is a valuable tool for assessing the risk-adjusted return of investments. By comparing returns against the risk-free rate and adjusting for volatility, it helps investors make informed decisions and compare different investment options. Despite one or two limitations, it remains crucial for evaluating and balancing investment risk and return.