The Sharpe ratio is a measure of investing efficiency developed by Nobel laureate William F. Sharpe. The ratio illustrates the average return earned on an investment in excess of the risk-free rate per unit of volatility (a measure of risk). The ratio can be found by subtracting the risk-free rate (typically treasury returns) from the mean return of the investment and then dividing that amount by the standard deviation of the portfolio return (a measure of volatility). The higher the output, the more efficient an investment is in earning returns given the amount of risk it is taking.
The Sharpe ratio is helpful in looking at investment performance from a risk-adjusted standpoint. Too often, investors look at investment performance from an absolute returns standpoint, preferring the security with the highest return to date. Unfortunately, that approach fails to take into account the critical element of risk. If one investment if returning slightly more than another but is taking on significantly more risk, it shouldn’t be considered a superior option. We want to be adequately compensated for the risk we take as investors and applying the Sharpe ratio can help us do that. Likewise, when we add an investment to our portfolio, we want to make sure that our overall portfolio Sharpe ratio increases as a result of added risk-return efficiency. If the addition of an investment causes the ratio to fall, it may not be a good addition.
Like many investing ratios, the Sharpe ratio is not without its limitations. When we apply the ratio to more complex investments with non-linear risks such as those of options or warrants, the ratio begins to break down and we must turn to other applications to understand the risk nature of our portfolio.