Sharpe Ratio

What Is Sharpe Ratio?

The Sharpe Ratio is used to calculate return on investment (ROI) for a project or investment. 

William F. Sharpe introduced the Sharpe ratio in 1966.

The Sharpe ratio calculates the expected returns from an investment in relation to its risks. The ratio is also called the Sharpe measure, Sharpe index, and the reward-to-variability ratio.

The Sharpe Ratio can be used to evaluate the risks and perform a cost-benefit analysis of an investment. In financial terms, the ratio calculates an investment's average return over an asset's risk-free rate. 

Using the Sharpe Ratio

Sharpe Ratio = Rp​−Rf​​

  σp​

where:

Rp ​ = return of portfolio

Rf​                = risk-free rate

σp​         = standard deviation of the portfolio’s excess return​

This means that if we evaluate two different investment choices, the option with a higher Sharpe ratio will be preferred as it shows a higher potential return than the other option. However, at times, the Sharpe ratio calculation can return a negative result, which can be interpreted as the risks being too high, or the market is too volatile for the investment. 

This means that the higher the result of a Sharpe ratio, the more attractive an investment option is. But bear in mind that even Ponzi schemes usually show high Sharpe ratios. In addition, Sharpe ratios can be manipulated through false inputs and inaccurate data. 

Many financial institutes, particularly fund managers, use the Sharpe ratio and other tools to assess portfolio performance. The ratio can also be used to evaluate portfolio returns and the stock market performance.