Definition – What is the Sharpe Ratio?
The Sharpe Ratio is the average return above the risk-free rate of return on an investment. The risk free rate of return is an investment in a US Treasury.
A high sharpe ratio means that the investment is making a lot of money above the risk-free rate of return.
A low sharpe ratio means that the investment is making only a little money above the risk-free rate of return.
A negative sharpe ratio means that the investment is making less money than risk-free investment such as a US Treasury.
Formula – How to calculate the Sharpe Ratio
Sharpe Ratio = (Expected Return – Risk Free Rate) / Portfolio Standard Deviation
Convert all percentages to a decimal (divide by 100%).
A stock has an expected return of 4.55%. The risk-free rate is 1.75%. The portfolio has a standard deviation of 0.20.
Sharpe Ratio = (0.0455 – 0.0175) / 0.20 = 0.028 / 0.20 = 0.14
Therefore, this stock’s Sharpe Ratio is 0.14, or 14%.
Sources and more resources
- Morningstar News – The Sharpe Ratio Defined – An introduction to the Sharpe Ratio.
- Wikipedia – Sharpe Ratio – Wikipedia’s entry on the Sharpe Ratio. Includes a discussion on how it can be used.
- Investopedia – Sharpe Ratio & Understanding the Sharpe Ratio – A pair of articles on how to use the Sharpe Ratio.