Sharpe Ratio: Formula, Calculation, and Importance

To quote Benjamin Graham, “The essence of investment management is the management of risks, not the management of returns”.

Risk management is the backbone of any investment, but many investors often overlook it. While financial markets are all about taking risks, it is crucial to differentiate between calculated risks and wild guesses.

Thorough analysis and calculated risks are key factors distinguishing investment from gambling.  

Over the years, several methods have surfaced to help investors map out the risks and rewards of every possible investment opportunity. The Sharpe ratio is one such tool that has been used by investors globally to calculate risk-adjusted returns on their investments. 

Read on to learn more about the Sharpe ratio and how it can benefit you.

Sharpe ratio meaning

Discovered in 1966 by William F. Sharpe, the Sharpe ratio in mutual funds helps you calculate its potential risk-adjusted returns. 

Simply put, it measures the additional return you receive for the amount of risk taken. It helps you understand the performance of your investment by evaluating its returns and risk profile.

A higher Sharpe ratio indicates your investment has generated better returns for the risk taken. On the other hand, a lower ratio means the returns are not sufficient for the level of risk involved.

Let’s understand how you can calculate the Sharpe ratio of your investments.

Sharpe ratio formula

You can calculate the Sharpe ratiousing this formula:

Sharpe ratio = (Average investment returns – Risk-free rate) / Standard Deviation of the investment’s returns.

Where,

- Average investment returns denote the past returns generated by the fund over a specific period.

- Risk-free rate refers to the returns generated by risk-free investment instruments—for example, bank FDs, treasury bills, and government or corporate bonds.

- Standard deviation is the volatility of the fund. For example, a fund with a standard deviation of 8% and an expected average return of 15% can provide a return of either 7% or 23%.

Let us understand Sharpe ratio calculation with an example.

Suppose there are two mutual funds.

Case 1: Mutual fund #1

Average investment rate = 30%

Risk-free rate = 5%

Standard deviation = 5%

Sharpe ratio = (30-5)/5 = 25/5 = 5

Hence, based on the inputs of this particular mutual fund, we get the Sharpe ratio as 5.

Case 2: Mutual fund #2

Average investment rate = 30%

Risk-free rate = 5%

Standard deviation = 12.5%

Sharpe ratio = (30-5)/12.5 = 25/12.5 = 2

Here, the Sharpe ratio of this mutual fund is 2.

Although the return-on-investment rate is the same for both funds, i.e., 30%, their Sharpe ratio vary significantly. This provides us with the following takeaways:

1. Even with an identical average return rate, mutual fund #1 performs better than mutual fund #2.

2. The Sharpe ratio indicates for the risk taken, mutual fund #1 provides a more attractive return than its counterpart.

3. Mutual fund #2 is a riskier option because it has high volatility, shown by the standard deviation.

Grading based on the Sharpe ratio

The Sharpe ratio is an excellent metric to assess which fund provides a better risk-adjust return. You can use it to compare funds in the following ways:

By a rule of thumb, funds with a Sharpe ratio between 1 and 2 are considered average, while those above 3 are considered really good investments. Similarly, funds with a Sharpe ratio below 1 should be avoided as these funds do not generate sufficient returns to compensate for the risk involved.

Importance of Sharpe ratio

The Sharpe ratio is a popular metric not just because of its simplicity and ease of calculation but also due to its overwhelming importance for investors:

1. Simplified investment analysis: The Sharpe ratio serves as a good gateway tool for beginners as it has little to no complicated calculations and can provide a straightforward result.

2. Comparing investment options: Investors use the ratio to compare mutual funds with the same average returns. A good Sharpe ratio helps them select funds with good risk-adjusted returns and make informed decisions.

3. Monitoring portfolio performance:Many fund houses include the Sharpe ratio in their monthly/quarterly portfolio disclosure to help investors monitor their portfolio performance and make adjustments per their risk-reward appetite.

Limitations of Sharpe ratio

The Sharpe ratio may seem to be a fool-proof tool for measuring the performance of various funds. However, it has its limitations:

1. Sharpe ratio, like most tools available, is based on historical returns and volatility. It assumes that the fund’s future performance will align with its past, which is hardly true in real life.

2. A significant drawback of the Sharpe ratio lies in its inability to distinguish between upward and downward volatility. As a result, even if an asset has a steep positive return, the ratio acknowledges the move as volatility, giving the asset a low metric. 

3. Sharpe ratio primarily captures risk caused by volatility. However, other forms of risks, like market risk, liquidity risk, and credit risk, are not acknowledged in its calculation.

4. The ratio works on the assumption that the returns are normally distributed, which may not hold true in real-world financial markets. With most assets exposed to other forms of deviations as well, the validity of the ratio is thus questionable.  

Parting thoughts

For veteran as well as beginner investors, Sharpe ratio calculationand assessment can be a good starting point when filtering out potential funds for investment.

However, with the financial markets being filled with multiple tools, the Sharpe ratio should not be the only form of differentiation when comparing different funds. You must compare the fund’s objectives, returns, and performance, as well as your financial goals and risk appetite, to make an informed decision.

Visit the Moneyfy website or download the Moneyfy app to compare top-performing mutual funds and select the best investment scheme.