What is the Sharpe Ratio?

The Sharpe ratio helps investors evaluate the risk-adjusted return of an investment or portfolio. It was developed by William F. Sharpe, who is one of the developers of the Capital Asset Pricing Model

and is essential for comparing different investment options based on their returns and risks. Sharpe

William F. Sharpe

Sharpe Ratio (1)

$$ \begin{equation} SR = \frac{R_p - R_f}{\sigma_p} \end{equation} $$

$R_f$ = Risk-free rate

$R_p$ = Average return

σ = Standard Deviation of return

Proxy of risk

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Interpretation of Sharpe ratio: return per unit of risk

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Evaluating a Sharpe ratio

A higher Sharpe ratio indicates a better risk-adjusted return, meaning that the investor is earning more return per unit of risk. A lower Sharpe ratio suggests that the additional return generated does not sufficiently compensate for taking risk.

Fallbacks of the Sharpe Ratio

• Assumes returns are normally distributed
• Treats all volatility equal

What is the risk-free rate?

The risk-free rate is the return on an investment with a riskless payout, meaning there is no chance of incurring losses.

The prevailing example of a risk free investment are debt securities of the US Treasury, also known as Treasuries

• What is a debt security?
• What are Treasuries?

Treasuries dictate the risk-free rate because the United States Government is considered to be the most secure borrower on Earth

The Government issues Treasurys on TreasuryDirect.gov