What Is the Sharpe Ratio and Why Is It Useful to Investors?

A fundamental piece of being an investor is tracking returns. You invested money—what happened next?

Professionals typically advise investors to adjust those returns to account for the money spent. If it cost $100 to make the investment, you’d subtract $100 from your returns to look at the amount your investment returned over and above costs: your net returns.

Professionals also advise investors to compare their returns to an appropriate benchmark. As benchmarks can track “the market” (really some portion of the market), a comparison can help you understand if your portfolio is performing better than a similar investment in a market index could have. The goal, of course, is outperformance.

But not all investments are equal. What professionals don’t always recommend, and what can be illuminating, is looking at your returns on a risk-adjusted basis. That is, how much did your portfolio return per unit of risk assumed? A modest return on a somewhat safe investment is different from a modest return on an investment with a high degree of risk.

Understanding the Sharpe Ratio

One of the foundational concepts of finance is that return is proportional to risk.¹ That is, more risky investments typically can have a higher potential for returns. However, to thoroughly evaluate a given investment it’s important to understand how much risk may be necessary to achieve a specific return. 

In 1966, Nobel Laureate William Sharpe (1990)² created the Sharpe Ratio to quantify the relationship between return and risk. It has since been one of the most widely used metrics in finance. The Sharpe Ratio tells you how well the return on an asset compensates for the risk you’ve taken. More specifically, it shows whether you’re making a greater return on an investment in exchange for the additional risk assumed with that investment.

In practical terms, the ratio is best used as a tool for comparison. Say, for example, that Fund A and Fund B are both small cap equity funds. Over the same period, how did each fund perform relative to the risk it assumed?  The fund with the higher Sharpe Ratio has generated more return relative to the risk. Remember though, that it’s important to compare apples to apples: a reasonable comparison holds when you’re looking at the same strategy over an identical period.

An investor can also look at how a fund’s Sharpe ratio changes over time to assess a manager’s performance through changing market conditions.  Another way to use the ratio is to consider the target return you wish to achieve and see which strategy or asset class has historically delivered similar returns with the least risk (i.e., the highest Sharpe ratio).  

The Sharpe Ratio and Risk

The Sharpe Ratio uses standard deviation as a measure of risk. In the simplest terms, the standard deviation is the average distance from the mean value in a data set. It’s expressed in the same units as the data set—in this case a percentage since we’re dealing with investment returns. The magnitude of the standard deviation, or how far the dispersion of returns extends, tells us how risky the investment is.   

Say that Portfolio A has an average annual return of 10% and the entire set of historical returns includes values as low as -15% and as high as 20%. Portfolio B has an average annual return of 8%, with the lowest return at -2% and the highest annual return at 10%. Portfolio A exhibits a dispersion of returns that is much wider than that of Portfolio B, therefore it has a greater standard deviation and is thus considered a riskier investment. 

The Sharpe Ratio Formula

To calculate the Sharpe Ratio, use this formula:

(R_x – R_f)/Standard Deviation R_x

• R_x is the expected portfolio return. 
• R_f is what many consider the “risk-free” rate of return (all investing involves risk), which is often a U.S. Treasury bill of short maturity.
• (R_x – R_f) is the market risk premium, or excess return
• Standard deviation R_x is the standard deviation of the risky asset(s). The lower the standard deviation, the less risk and the higher the Sharpe Ratio. Conversely, the higher the standard deviation, the more risk and the lower the Sharpe Ratio.

The components of the Sharpe Ratio calculation are easy to find. The Treasury bill rate used for the “risk-free” rate can be found at the U.S. Department of the Treasury web site, while standard deviations are available through financial websites like Yahoo Finance, Morningstar, Bloomberg, and others.

The equation makes clear the relationship between risk and return, illustrating how much excess return is received for each unit of additional risk. The higher the ratio, the greater the expected investment return relative to the risk assumed.

Applying the Sharpe Ratio

You can use the Sharpe Ratio to evaluate the performance of a portfolio as compared to a benchmark or another portfolio. Let’s assume a “risk-free” rate of 4%.

Portfolio A has historically returned 15%, while Portfolio B has historically returned 12%. Without any consideration of risk, Portfolio A appears to be the better choice based on past returns. 

However, Portfolio A has a standard deviation of 9% and Portfolio B has a standard deviation of 5%.

Now, let’s calculate the Sharpe Ratio for each.

Portfolio A: (15-4)/9 = 1.2

Portfolio B: (12-4)/5 = 1.6

Based on Portfolio B’s Sharpe Ratio of 1.6, it provided a superior return on a risk-adjusted basis. Looking at it another way, each unit (percentage point) of Portfolio B’s return is generated with a lower level of risk (as expressed by standard deviation).

In general, a Sharpe Ratio between 1 and 2 is considered good. A ratio between 2 and 3 is very good, and any result higher than 3 is excellent, 

Limitations of the Sharpe Ratio

One of the most significant limitations of the Sharpe ratio is that it’s calculated using historical data and is therefore backward looking. Market conditions change, and consequently, it’s not indicative of future returns.

It also assumes that investment returns are normally distributed in the shape of a bell curve. In a normal distribution, historically more returns are grouped symmetrically around the mean and fewer returns are found in the “tails” of the bell curve.³

Unfortunately, normal distributions fail to take large market moves into account, and volatility may be higher in one direction than the other. When distribution values cluster in the tail and show higher peaks, or when the distribution lacks symmetry around the mean, standard deviation becomes less effective as a measure of risk. 

When the standard deviation fails to accurately represent the risk assumed, the result can be a Sharpe Ratio that is higher or lower than it should be. 

Despite this limitation, the Sharpe Ratio can be useful because it offers a simple and intuitive way to look at a portfolio’s risk-adjusted return. While it may not be perfectly accurate in the event of large market moves, it nonetheless gives us a starting point from which to compare investments.

The Takeaway

Some professional investors use the Sharpe Ratio as one element in their toolkit to evaluate investment performance, and it can be a useful tool for retail investors as well. It’s popular because it’s easy to calculate and interpret. Many mutual funds, for example, publish the portfolio’s Sharpe Ratio as part of quarterly and annual performance updates they distribute to clients. 

Even if the details of calculating expected returns and standard deviation are disagreeably complex, any investor can understand that the higher the Sharpe Ratio, the more attractive the return is relative to the risk taken, thus the more attractive the investment.