WHAT IS SHARPE RATIO?
HOW DO I USE IT?
The Sharpe Ratio, named after Nobel laureate William F. Sharpe, measures the rate of return in association with the level of risk used to obtain that rate. It’s a particularly useful tool for novice investors to use as a method tracking “luck” versus “smarts”.
Sharpe Ratio Example
Here’s an easy example to help conceptualize how the Sharpe Ratio works in real life. You and your two friends are out for a drink when the topic turns to investing. Friend number one is the play it safe guy who puts his money in Treasury Bonds and hopes for the best. Essentially his investment is as close to risk free as possible (excluding the threat of inflation of course). It’s safe and requires nothing more than automatic payroll deductions to generate a steady – albeit decidedly insignificant – rate of return.
This is considered a “risk free” rate. Since anyone can obtain that rate of return by doing almost nothing, it is removed from the equation. Stocks, by their very nature, have some element of risk and as a rule of thumb, any investment with an element of risk should generate a premium above the risk free level…otherwise, why put your money at stake?
Friend number two is telling you about his hot new investment tip that just generated an amazing 25 percent rate or return. Is this guy a genius or what? Maybe not. By using the Sharpe Ratio, you can measure whether your friend is taking on too much risk. Briefly, the Sharpe Ratio works like this…
Subtract the risk free rate (like that available from your friends Treasury bills) from the rate of return generated then divide by the standard deviation of the portfolio returns. The result provides a way to measure the excess return derived from the level of risk assumed…not necessarily insight and intuition. Chances are your friend isn’t a genius but rather a lucky hot-shot who needs to take the money and run before his luck runs out.
To give you some insight, a good sharpe ratio is 1 or better, 2 and better is very good, and 3 and better is considered excellent.
One final note: if your investment portfolio isn’t performing above the risk free rate then it’s time to put up or shut up. Either figure out what you are doing wrong and begin educating yourself on the basics of investing or sign up for those bonds via payroll deduction and hope inflation leaves you a little to live on by retirement.
Sharpe Ratio Calculation
Let’s consider 2 blue chip stocks for a sharpe ratio example:
Apple’s and McDonald’s
Let’s assume that theoretically, the average annual rates of return on Apple and McDonald’s stocks for the last 5 years were 30% and 25%, respectively.
It would be very tempting to easily pick Apple as the winner here because c’mon – it’s thereturns that count when picking stocks, right?
RIGHT and WRONG?
Right because yes, it’s about the expected returns. Wrong because our expected returns can be influenced by its historical volatility as well.
Let’s assume that the computed average standard deviations for Apple and McDonald’s average annual returns are 15% and 10%, respectively.
In layman’s terms, it means that the expected annual return this year for Apple’s and McDonal’s stock are expected to be:
Apple: between 45% (30% + 15%) and 15% (30% – 15%)
McDonald’s: between 35% (25% + 10%) and 15% (25% – 10%)
Further, let’s assume that the risk-free rate, or the average rate of return on government securities is 1%.
Now its time to see what the late Mr. William F. Sharpe has to say about these 2 stocks.
The sharp ratio formula is the following:
(Average or Expected Return – Risk Free Rate) ÷ Standard Deviation
Given the formula, we can now decipher Mr. Sharpe’s opinion on the 2 stocks.
Apple: (30% – 1%) ÷ 15% = 1.93
McDonald’s: (25% – 1%) ÷ 10% = 2.40
As explained earlier, the higher the Sharpe Ratio numbers are, the better.
It’s because the difference between a stock’s expected real return, i.e., over and above the risk-free rate of investment, and its risk becomes greater with higher Sharpe Ratio numbers. It means your risk-taking may be compensated more.
That being said, it’s now time to declare who the real winner is.
The winner by Sharpe’s unanimous decision is…
McDonald’s!!! (2.40 > 1.93)
Success? I hope so. But don’t stop there! There are plenty of other ways to help your investing strategy. You can learn the more advanced types of investing in Understanding Advanced Techniques