Sharpe Ratio

We know that investors “purchase” investment returns by parting ways with their money and accepting risk. The risk, of course, is that the money will not earn the return that was expected or, worse yet, that not of all of the money is even returned.

Investors are often concerned about returns. They want to know what the investment has returned in the past. They also want to know what the return is likely to return in the future. Unfortunately, while we usually know the former, the latter is unknown. Past performance is no guarantee of future results and future performance may be lower than past performance. We need to look no further than the market crash of 2007-2009 to see that markets can deliver terrible performance.

While investors should be concerned about performance, they should be even more concerned about risk-adjusted performance. The question is how much risk must an investor assume in order to receive the anticipated return. Given two similar investments that have identical returns, investors should select the investment with the lower risk. Alternatively, given two investments with identical risk, investors should select the investment with the highest return.

Nobel Laureate William F. Sharpe developed a formula to measure risk-adjusted returns. The Sharpe Ratio is calculated by subtracting the risk free rate from the rate of return for the investment (or a portfolio) and then dividing that result by the standard deviation of returns. The proxy for the risk free rate is Treasury Bills. We learned in an earlier post on my blog that standard deviation is a measure of risk.

We can compare investments using the Sharpe Ratio. The investment with the higher Sharpe Ratio is the preferred investment. We can also use the Sharpe ratio to simply evaluate performance in isolation. The higher the Sharpe Ratio, the better. A negative Sharpe Ratio suggests that a risk free investment would have performed better.

Intelligent Investors are very concerned about risk-adjusted returns.