Sharpe ratio
The Sharpe ratio divides the return earned above the risk-free asset by the volatility taken on to get it. It answers how much was gained per unit of risk borne, and allows comparison between strategies that would make no sense judged on raw return alone: making 20% through constant lurches is not the same as making 12% without them.
How it is calculated
Sharpe ratio = (portfolio return − risk-free rate) ÷ portfolio volatility. It measures how much extra return you get per unit of risk taken. A portfolio returning 12 % with 15 % volatility, when the risk-free rate is 3 %: (0.12 − 0.03) ÷ 0.15 = 0.6. Another returning 8 % with 6 % volatility gives (0.08 − 0.03) ÷ 0.06 = 0.83, and is better by this measure even though it earns less. Sharpe ratios are only comparable when computed over the same period and with the same risk-free rate.
The figures in the example are invented and rounded so the arithmetic can be redone by hand. They are not data from any real company.
What it is NOT
It does not measure the risk of losing money: it measures variability, and it penalises upward moves exactly as much as downward ones. A portfolio that rises in large jumps is penalised even if it has never lost. It also assumes returns follow a normal bell curve, and market returns do not: extreme falls are more frequent than that assumption allows, so Sharpe tends to flatter strategies that do well almost always and terribly once in a while.
Formula
Sharpe = (Rp − Rf) ÷ σp See also
See it on real data
Celsmar computes this from the accounts companies file with their regulator, and shows which line every figure comes from. Free to start, no card.
Definition for informational purposes. It is not financial advice nor a recommendation to buy or sell.