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What Is the Sharpe Ratio?

Chime Team • July 11, 2024

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Sharpe Ratio

The Sharpe ratio, developed by Nobel Prize-winner William F. Sharpe, is a financial tool that helps investors evaluate the performance of an investment by adjusting for its risk.¹

Essentially, the Sharpe ratio indicates how much additional return an investment provides for each unit of risk taken compared to a risk-free asset. It may sound complex, but understanding it can make a difference in how you manage your investments – even if you’re just beginning your investment journey.

This metric allows investors to compare different investment options on an equal footing. With the Sharpe ratio, you can determine if you’re being adequately compensated for the risks you’re taking or if you could achieve similar returns with less risk elsewhere. This is particularly useful in a world where higher returns often come with higher risks.

The Sharpe ratio dates back to 1966 when William Sharpe introduced it to quantify the reward-to-volatility trade-off.² Since then, it has become a standard tool for evaluating asset and portfolio performance.

Now, it’s widely used by financial professionals and individual investors alike, making it a valuable metric to understand if you’re looking to improve your investment strategy.

For everyday investors, knowing how to use the Sharpe ratio can lead to more nuanced investment decisions. It provides a way to measure if taking on additional risk is worth the potential rewards or if a lower-return investment might actually offer a better risk-adjusted result.

For instance, an investment with a lower return but also lower volatility might be more appealing if it offers a higher Sharpe ratio than a high-return, high-volatility investment. In other words, the ratio helps investors answer the question: “is it worth the risk?”

How to calculate the Sharpe ratio

To calculate the Sharpe ratio, subtract the risk-free rate of return from the portfolio’s rate of return and divide the result by the portfolio’s standard deviation.

The risk-free rate is typically represented by the return on government bonds, considered one of the safest types of investments.³ The standard deviation measures how much the investment returns vary over time. A higher Sharpe ratio indicates better risk-adjusted returns, meaning you’re getting more return for each unit of risk taken.¹

For example, imagine you’re looking at two mutual funds. Fund A has a Sharpe ratio of 1.2, and Fund B has a Sharpe ratio of 1.5. Fund B offers more returns per unit of risk and might be the better choice if you’re cautious about risk.

However, past performance doesn’t guarantee future results, so the Sharpe ratio should be one of several factors in your investment decision-making process.

The Sharpe ratio and personal finance

Understanding the Sharpe ratio can significantly impact personal finance and investing. It encourages careful risk management, pushing investors to consider not just high returns but also the potential downsides.

This balanced approach can lead to more informed investment strategies that withstand market fluctuations and reduce the likelihood of significant losses. Diversification, in particular, can help mitigate risk, as spreading investments across various asset classes can reduce the impact of a poor-performing investment on your overall portfolio.

Incorporating the Sharpe ratio into your financial planning can also help you set more realistic and achievable goals.

The Sharpe ratio is a fundamental measure that helps investors assess the risk-adjusted performance of their investments. It emphasizes the importance of managing risks alongside seeking high returns.

By making informed decisions based on the Sharpe ratio, investors can strive for more stable and consistent portfolio growth, aligning their choices with their financial goals and risk tolerance. This approach can lead to a more resilient investment portfolio that can weather market ups and downs.

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1 Information from Corporate Finance Institute's "Sharpe Ratio" as of June 28, 2024: https://corporatefinanceinstitute.com/resources/career-map/sell-side/risk-management/sharpe-ratio-definition-formula/

2 Information from Business Insider’s “Understanding the Sharpe Ratio: An Explainer for Investors” as of July 1, 2024: https://www.businessinsider.com/personal-finance/sharpe-ratio

3 Information from Forbes’ “The Risk-Free Rate” as of June 28, 2024: https://www.forbes.com/advisor/investing/risk-free-rate/

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