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Sharpe Ratio Definition
Sharpe ratio is defined as the ratio between effective return of an investment and its standard deviation.
Rp – Rf / σp
Rp = expected return on investor’s portfolio
Rf = risk free rate of return
σp = the portfolio’s measure of risk or standard deviation
Sharpe Ratio explanation
- It is a ratio between the difference of the return on the portfolio and risk free rate by standard deviation of the portfolio’s excess return.
- Sharpe ratio helps us understand whether portfolio excess returns are due to sound business decision or a result of undertaking very high risk.
- A higher Sharpe ratio is better than a lower one because it will indicate that the portfolio is making a good investment decision
- When the portfolio has a higher return than that of its competitors, it is a good investment. A high return with the same level of risk !
Sharp ratios can fall into 4 broad categories –
- < 1 – Bad
- 1 to 1.99 – Ok
- 2 to 2.99 – Good
- > 3 – Excellent
Sharpe Ratio by example
Let us assume the expected return from your stock portfolio is 14%. If return on risk free T-notes are 3%, and your portfolio carries a standard deviation of 5, the Sharpe portfolio can be calculated as:
(14 – 3) / 5 or 2.2
Which portfoilio would you choose?
Portfolio A generates a 8% return with a 1.50 Sharpe ratio and portfolio B also generates a 8% return with 1.25 Sharpe ratio.
A is the clear winner here. You are getting the same return with a lesser risk.
The higher the Sharpe ratio is, the higher the return an investor gets by bearing a unit of risk. The lower the Sharpe ratio is, the more risk the investor is bearing to earn additional returns. There are few assumptions which can be misleading to the investors. The main fallacy is due to the assumption of investment returns being normally distributed. Returns can be skewed or have other characteristics not described by normal distribution.
How to calculate Sharpe Ratio in Excel
1. First, enter annual returns of your portfolio such as ETF or Mutual Fund. You can get this information from your broker or online sources such as Yahoo or Google finance.
2. Second is the risk-free return rate. This can typically be a treasury bill or T–bill. T-bills are considered nearly free of default risk becuase they are fully backed by the U.S. government. The Daily Treasury Yield Curve Rates are referred to as “Constant Maturity Treasury” rates or CMTs.
3. Third, take the difference between risk free return rate and actual return. This is the excess return. Call it as delta.
4. In the end, do the following
- Take the average of the Delta or excess return
- Take the Standard Deviation of Delta use STDEV function
- Lastly, take the ratio between average of Delta returns and Standard Deviation. This is your Sharpe Ratio.
Be sure to check the Modified Sharpe Ratio once you get grounded with the Sharpe ratio calculator.