What Is a Sharpe Ratio and How To Use It While Investing
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TL;DR: The Sharpe ratio helps investors measure how well they’re being compensated with excess returns in exchange for holding riskier assets. The Sharpe ratio can be applied both to individual assets or an entire portfolio. It can be complicated to calculate by hand, so Pickilo has developed a comprehensive portfolio management software that will automatically calculate the Sharpe ratio and other crucial metrics so you don’t have to worry about doing the calculations on your own.
In the finance world, the Sharpe ratio is still viewed as one of the best and most straightforward ways to measure the risk-adjusted return of an investment or portfolio–essentially, it shows how much of a reward you’ll receive for holding a riskier asset.
It’s been used for decades now since it was developed by economist William Sharpe in 1966 and is still relied upon by financial professionals around the globe. Plus, it works just as well with individual securities as it does when applied to an entire portfolio.
So with the versatility of this metric combined with the confidence that finance professionals still hold with the Sharpe ratio, it will continue to be a widely used metric for the years to come. However, the Sharpe ratio formula and how to calculate it can oftentimes be a sticking point for beginner investors who don’t have the proper tools and resources at hand.
Continue reading through this guide as we discuss what is a Sharpe ratio, how to calculate it, and what is a good Sharpe ratio to look out for. With a better understanding of the Sharpe ratio, you will be able to see why it’s such an important metric to track in your own portfolio.
Sharpe Ratio Defined
Before we can dive into what is a good Sharpe ratio and the implications of this metric, let’s take a deeper look at the definition of the ratio, and the various components that go into its calculation.
If you still don’t know what is a Sharpe ratio, it’s the metric that compares the performance of an investment to the risk-free rate of return–typically the yield on U.S. Treasury bonds or bills. Again, it shows you how much of an excess return you can expect by making a riskier investment. This is because investors need to be rewarded for not holding risk-free assets and withstanding greater risk and volatility.
So, you could say that the Sharpe ratio shows investors exactly what your risk/return tradeoff is.
Most financial professionals are very familiar with the Sharpe ratio and what it means, though if you are still new to learning about it, we will walk you through each of the elements that make up the Sharpe ratio formula.
To calculate the Sharpe ratio, you’ll need to know the expected rate of return for your investment. Think through the different scenarios that are possible for the security–whether it will see a gain or a loss in the coming periods. For each scenario, multiply the gain or loss by the probability that this outcome will occur. Then, you can add up the values you get from each scenario to result in your expected return.
As a reminder, all the different probabilities you come up with must add up to 100%.
For instance, think of a situation where a security has a 30% chance of seeing a +15% return, a 50% chance of having a +5% return, and a 20% chance of a (10%) return. In this case, your calculation for the expected return would look like this:
Expected return = (30% x 15%) + (50% x 5%) + (20% x -10%)
Expected return = 4.5% + 2.5% – 2%
Expected return = 5%
This means that if a security is currency trading at $100, you expect it to increase to $105 by the end of your projected time period.
This step will take some time to think through each of the various outcomes possible for a security. And if you want to learn how to calculate Sharpe ratio for the entire portfolio, you’ll need to repeat this step for each security you own. Then, you’ll take a weighted value of the expected return for each stock based on its position in your portfolio to get the expected return for your entire portfolio.
Next, you’ll need to identify the risk-free rate to use in the Sharpe ratio formula. You utilize this metric as a way to see if you’re being rewarded for taking on greater risk with your chosen investment, as compared to what people earn when they hold risk-free investments.
In most cases, investors will use the rate of return on the shortest-dated U.S. Treasury bill, which has the least volatility of all securities on the market and is the closest metric we have to a risk-free rate. There is still some debate in the community as to what securities should be utilized to determine the risk-free rate when calculating the Sharpe ratio, though the U.S. Treasury bills are still the most widely used in this formula.
By subtracting the risk-free rate of return from the expected return of your investment, we can see what the excess return is that compensated you for the added risk exposure. From there, you divide the excess return by the standard deviation of the investment in order to find the Sharpe ratio.
Having a large standard deviation could throw off the results of the Sharpe ratio because the formula of this metric relies on returns that are normally distributed for the best accuracy. However, unless the standard deviation is significantly large, you should be okay to calculate the Sharpe ratio as is, as most investments today do not show normally-distributed returns.
Sharpe Ratio Formula
Now that you understand each of the elements that make up the Sharpe ratio formula, let’s take a look at the calculation altogether:
Sharpe Ratio = (Expected Return – Risk-free Return) / Standard Deviation
Let’s walk through an example of how to use the Sharpe ratio formula. Let’s assume we have shares in ABC company, which has an expected return of 9%, and the risk-free rate is 3.67% using the yield on the 10-year Treasury Bill. If the standard deviation of the returns on ABC company is 15%, we have a Sharpe ratio of:
Sharpe Ratio = (9% – 3.67%) / 15%
Sharpe Ratio = 5.33% / 15%
Sharpe Ratio = .355
Understanding how to calculate Sharpe ratio is only the first step. Now we need to take a look at how to analyze the Sharpe ratio to see what it tells you about your portfolio.
What Does the Sharpe Ratio Tell Us–What Is a Good Sharpe Ratio?
Being able to interpret the Sharpe ratio can give you important insights into the investments you have.
So let’s get right into the question you probably have at this point–what is a good Sharpe ratio?
- Sharpe ratio > 1.0 = acceptable
- Sharpe ratio > 2.0 = very good
- Sharpe ratio > 3.0 = excellent
- Sharpe ratio < 1.0 = sub-optimal
The goal for investors here is to get the highest rate of return for the lowest level of risk, which will drive the Sharpe ratio calculation higher.
So as you could gather, changes to each of the variables listed in the above section could result in a better Sharpe ratio–or a worse one for that matter. For instance, if the expected rate of return were higher for the security, or the risk-free rate was lower, you would get a higher Sharpe ratio all things equal. In addition, the higher the standard deviation, the lower it will make the Sharpe ratio.
Intuitively each of these variations’ impact on the Sharpe ratio makes sense. But, let’s take a look at a different example from the one above to see how this looks in practice.
For company XYZ, instead of an expected rate of return for the stock of 9%, let’s assume 12% and leave the risk-free rate as is. Rather than a standard deviation of 15%, this company has a standard deviation of 8%. Here is what the Sharpe ratio for this security looks like:
Sharpe Ratio = (12% – 3.67%) / 8%
Sharpe Ratio = 8.33% / 8%
Sharpe Ratio = 1.04
So, in this new scenario, the Sharpe ratio is at a level that investors would deem acceptable, meaning there is a good return at the level of risk that investors assume by owning this stock.
What is a Sharpe Ratio in a Portfolio?
Each of the examples we’ve covered so far has shown the Sharpe ratio for individual securities. In reality, most investors will have a larger portfolio where they’ll hold more than one company’s stock.
To find the Sharpe ratio of your portfolio, you can’t just take the Sharpe ratio for each individual asset and take a weighted value given the size of each position in your overall portfolio. You need to calculate the Sharpe ratio in the same way for individual assets by taking the actual or expected return of the entire portfolio, subtracting the risk-free rate, and then dividing by the standard deviation of the portfolio.
However, as we discussed above, you’ll want to be careful about how you analyze the Sharpe ratio of your portfolio when you have investments with an abnormal distribution of returns. In this case, it could inaccurately skew the ratio higher, making you feel like you’re exposed to less risk when in reality, it could be the exact opposite.
Pickilo Helps with How to Calculate Sharpe Ratio
As you can see, understanding what is a Sharpe ratio and how to analyze this metric can be very helpful as you manage your portfolio and identify new investment opportunities that are worth the risk exposure. However, you could see where the calculations could get out of hand and become overwhelming to the everyday investor who’s interested in the stock market.
With Pickilo, you don’t have to worry about how to calculate Sharpe ratio or the various elements that go into the formula–we take care of it all for you so you can focus on taking action and watching your account balance grow. Understanding your overall portfolio Sharpe ratio is especially important today with the heightened risk of an upcoming recession.
We have the ultimate portfolio management software that automatically connects to your brokerage accounts, giving you real-time updates and deep insights into your portfolio and how it’s performing. Plus, not only can you compare your portfolio performance against major indices and benchmarks, but you can also see how your portfolio stacks up against other investors like you on Pickilo.
We know the various financial metrics, like the Sharpe ratio, can be a bit overwhelming and confusing. However, this doesn’t mean that it’s a useless piece of information that you can overlook. That’s why Pickilo automatically tracks and analyzes your portfolio performance, dividend income, asset allocation, and risk using industry-standard metrics so you don’t have to.
No more complex formulas–only valuable insights. Stop being in the dark about your investments and start managing your portfolio like a professional. Try Pickilo for free today.