Sharpe ratio

What is the Sharpe ratio?

The Sharpe ratio, developed by Nobel laureate William F. Sharpe, is a measure that evaluates the risk-adjusted return of an asset or entire investment portfolio.

To calculate the Sharpe ratio, subtract the risk-free rate of return (which is usually represented by government bond yields) from the expected return of the portfolio. From there, divide the difference by the portfolio's standard deviation, which represents its total risk.

The formula for the Sharpe ratio looks like this:

E (Rp - Rf) / σp

E(Rp) is the expected return of the portfolio
(Rf) is the risk-free rate
σp is the standard deviation of the portfolio's excess return

The Sharpe ratio helps investors understand how much excess return they may receive for the extra they take on. A higher Sharpe ratio indicates a more favorable risk-adjusted return. In other words: The investment may have the potential for more return per unit of risk. On the other hand, a lower Sharpe ratio suggests that the returns do not adequately compensate for the risk involved.

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