Risk-adjusted returns are probably something you’ve heard investors talk about. This is a method of determining how well an investment performed when risk is taken into account—specifically, the additional risk required to obtain higher returns. The Sharpe ratio is a way to figure out how your investments’ returns compare to their risks.
What does the Sharpe ratio mean?
Only the expected return on investment can be used to judge it. But you can understand an investment better when you know how much risk you took with a single stock or your entire portfolio to get those returns. This is what it means for returns to be based on risk.
The Sharpe ratio, which is also called the modified Sharpe ratio or the Sharpe index, is a way to measure an investment’s performance while taking risk into account. It can be used to judge a single security or a whole portfolio of investments. In either case, the investment with the best risk-adjusted return is the one with the highest ratio.
By comparing the return on investment to the extra risk it has over a risk-free asset, usually a U.S. Treasury security, the Sharpe ratio shows investors whether higher returns are enough to make up for the extra risk they are taking.
What does the Sharpe ratio do?
Most investors have two goals that are at odds with each other. First, they always want to get as much money back from their investments as possible. Second, they try to reduce risk, which is another way of saying that they want to lose as little money as possible.
The Sharpe ratio tells investors their risk-adjusted returns by giving them a score. It can be used to look at past performance or to predict what will happen in the future. Either way, this important financial ratio helps the investor figure out if the returns are because of smart decisions or because the investor took on too much risk. If it’s the second option, investors could lose more than they can handle when the market changes.
The Sharpe ratio is worked out by figuring out the “excess return” of an asset or a portfolio over a certain amount of time. This amount is divided by the standard deviation of the portfolio, which is a way to measure how volatile it is.
An Example of a Sharpe Ratio
Consider two portfolios: Portfolio A is expected to earn 14% over the next 12 months, while Portfolio B is expected to reach 11% over the same time period. Without thinking about risk, returns alone show that Portfolio A is the better choice.
What about risk, though? Here is where the Sharp ratio helps you see your investments in a more complete way. In this case, Portfolio A has a standard deviation of 8%, which means it is riskier than Portfolio B (less risk). The risk-free rate is 3%, which is the yield on a U.S. Treasury security with a medium-term maturity.
Now, let’s figure out what each Sharpe ratio is.
- The Sharpe ratio for Portfolio A is 1.38.
Portfolio B: (11–3)/4 = 2 for Sharpe ratio
The Sharpe ratio of Portfolio A is lower than that of Portfolio B because Portfolio A is more volatile. With a Sharpe ratio of 2, this shows that Portfolio B has a better return when risk is taken into account. - Generally, a Sharpe ratio between 1 and 2 is a good number. A ratio between 2 and 3 is excellent, and anything above 3 is even better.
What the Sharpe Ratio Can’t Do
It’s important to remember that the Sharpe ratio assumes that the average returns on an investment follow a standard curve. In a normal distribution, most of the returns are clustered around the average, and the tails of the curve have fewer returns.
Normal distributions don’t really show how financial markets work in the real world. Investing returns don’t follow a normal distribution over the short term. The volatility of the market can be higher or lower, and the returns on a curve tend to cluster around the tails. This can make it harder for the standard deviation to be a good way to measure risk.
When the standard deviation doesn’t show the risk well enough, the Sharpe ratio can be higher or lower than it should be.
Then there’s leverage, which is taking on debt in order to get a bigger return on investment. When you use leverage, your investment is more likely to lose money. If the standard deviation goes up too much, the Sharpe ratio will go down a lot, and the size of any loss will be a lot bigger. This could cause the investor to get a margin call.
In conclusion
Investors often use the Sharpe ratio to measure how well an investment has done. Part of its popularity comes from how easy it is to figure out and understand the ratio.
Many mutual funds, for example, tell their clients about the Sharpe ratio of their portfolios when they send out quarterly and annual performance reports.
Even if the details of calculating expected returns and standard deviation are annoyingly complicated, any investor can understand that the higher the Sharpe ratio, the better the return is compared to the risk taken, and therefore the better the investment.
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