As an investor, your objective is to balance the potential for returns with risk. When assessing risk, investors and financial advisors often apply the Sharpe ratio to their investment analysis. Just one popular method for evaluating stock, the Sharpe ratio is a tool of technical analysis that helps investors and portfolio managers determine the return on investments compared to the risk. Here’s a closer look at the Sharpe ratio and how you can apply this calculation to your portfolio.
Sharpe Ratio Explained
Developed by economist and Nobel laureate William F. Sharpe, the Sharpe ratio helps investors evaluate the return of an investment compared to the risk involved. This ratio is calculated by subtracting the risk-free rate of return from the investment’s rate of return and then dividing the outcome by the standard deviation, or the total risk, of the investment’s return. Generally, investors use U.S. Treasury Bond returns as the risk-free rate because it’s assumed the government won’t default on its debt payments.
For example, let’s say you have an investment with a rate of return that is 14%, a standard deviation that is 12%, and the risk-free rate of return is 2%. You would determine the Sharpe ratio by subtracting 2% from 14% and then dividing the result (12%) by 12%. This would give you a Sharpe ratio of 1, which is considered acceptable to investors. As a general rule, anything above 2 is very good, while above 3 is excellent.
The result of the calculation will determine if returns are due to smart investment selections or a product of taking on excess risk. One portfolio may reap greater returns than the next, so it may only be a good investment choice if the return doesn’t come with a higher level of risk exposure.
Why the Sharpe Ratio Is Important
The Modern Portfolio Theory suggests that by adding investments that have low correlations to a diversified portfolio, the investor may be able to reduce their risk exposure without forfeiting returns. Therefore, by adding diversified assets to a portfolio, the Sharpe ratio should increase in comparison to other portfolios with less diversification. However, investors must assume that risk and volatility are equal for this evaluation to be true.
Investors can use their real returns and the Sharpe ratio to assess past and future portfolio performance. The outcome may indicate if the investor took on excess risk to achieve greater returns. Additionally, investors can use expected portfolio returns and the probable risk-free rate to predict the future Sharpe ratio.
Typically, the higher the Sharpe ratio, the more attractive the return and the better the investment. However, if the calculation results in a negative Sharpe ratio, it means one of two things: either the risk-free rate is greater than the portfolio’s return, or the portfolio should anticipate a negative return. In both cases, a negative Sharpe ratio shows that the investment is worse than the risk-free rate and you might be better off not making that investment at all.
Limits of the Sharpe Ratio
The Sharpe ratio is a relative measure of risk-adjusted return. If evaluated alone, it may not provide the appropriate data to assess a portfolio’s actual performance. Furthermore, the ratio uses the standard deviation, which assumes equal distribution of returns. This means that the Sharpe ratio doesn’t account for other factors that may impact fund performance.
Since standard deviation accounts for positive and negative deviation returns, it doesn’t accurately measure the negative impact of risk because it could be skewed by a higher number of positive returns. Standard deviation assumes that any movement in price, either up or down, is equally risky, though downward movement would result in losses, while upward movement would result in gains.
Additionally, portfolio managers may try to manipulate the Sharpe ratio to give the illusion of historically positive returns to attract more clients. They can accomplish this by extending the measurement snapshot, which may cause a lower estimate of volatility or risk. For instance, applying an annual standard deviation of daily returns will give you a higher ratio than using weekly returns, and so on.
Sharpe Ratio Alternatives
The Sortino ratio is an alternative performance metric. The Sortino ratio differentiates toxic volatility from complete volatility by using the investment’s standard deviation of negative asset returns. Experts refer to this as the ‘downside of deviation’ in contrast to the standard deviation that accounts for total portfolio returns. Essentially, it’s removing the upward price movement. In some cases, utilizing the Sortino ratio removes the confines of the Sharpe ratio.
The Treynor ratio is another Sharpe ratio alternative. This variation uses a portfolio’s beta or market correlation rather than the standard deviation or total risk. An investor can use the Treynor ratio to determine whether a greater return is worth the risk of a volatile investment. To calculate the Treynor ratio, subtract the risk-free rate from the return of the portfolio and then divide by the portfolio’s beta. While the Treynor ratio is a good alternative to the Sharpe ratio, it looks at the historic performance of an investment, which doesn’t necessarily accurately determine the future of that investment.
The Bottom Line
As useful as the Sharpe ratio may be, volatility is only one factor to consider when assessing the quality of an investment. It’s also wise to consider a company’s balance sheet strength, profitability and strategic positioning.
One of the best ways to reduce risk is diversifying your portfolio. You may want to enlist the help of a financial advisor to properly diversify your investments. But before you do, consider the questions you should ask a financial advisor.
Risk Assessment Tips
- Instead of manually performing your own technical analysis, you might work with a financial professional who can analyze and choose investments on your behalf. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- Whether you work with a money manager or take a DIY approach, an important first step is to choose the right asset mix for your portfolio. To see what’s right for you, use our asset allocation calculator. This investment tool considers your time horizon and risk tolerance to give you a snapshot of what different investment portfolios could look like based on your risk tolerance.
- Assess different investments with low correlations. Investments with low correlations may help minimize the volatility in your portfolio.
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