Sharpe Ratio Formula and Definition With

Examples
By 
JASON FERNANDO
 

Updated June 06, 2022

Reviewed by MARGARET JAMES

Fact checked by 
KATRINA MUNICHIELLO
Michela Buttignol

What Is the Sharpe Ratio?

The Sharpe ratio compares the return of an investment with its risk. It's a
mathematical expression of the insight that excess returns over a period of
time may signify more volatility and risk, rather than investing skill.1

Economist William F. Sharpe proposed the Sharpe ratio in 1966 as an

outgrowth of his work on the capital asset pricing model (CAPM), calling it
the reward-to-variability ratio.1 Sharpe won the Nobel Prize in economics
for his work on CAPM in 1990.2

The Sharpe ratio's numerator is the difference over time between realized,
or expected, returns and a benchmark such as the risk-free rate of
return or the performance of a particular investment category. Its
denominator is the standard deviation of returns over the same period of
time, a measure of volatility and risk.

KEY TAKEAWAYS

 The Sharpe ratio divides a portfolio's excess returns by a measure of

its volatility to assess risk-adjusted performance
 Excess returns are those above an industry benchmark or the risk-
free rate of return
 The calculation may be based on historical returns or forecasts
 A higher Sharpe ratio is better when comparing similar portfolios.
 The Sharpe ratio has inherent weaknesses and may be overstated
for some investment strategies.

Sharpe Ratio

Formula and Calculation of Sharpe Ratio

In its simplest form,

Sharpe Ratio=��−����where:��=return of portfolio��=
risk-free rate��=standard deviation of the portfolio’s excess 
returnSharpe Ratio=σpRp−Rfwhere:Rp=return of portfolioRf=risk-
free rateσp=standard deviation of the portfolio’s excess return
Standard deviation is derived from the variability of returns for a series of
time intervals adding up to the total performance sample under
consideration.
The numerator's total return differential versus a benchmark (Rp - Rf)  is
calculated as the average of the return differentials in each of the
incremental time periods making up the total. For example, the numerator
of a 10-year Sharpe ratio might be the average of 120 monthly return
differentials for a fund versus an industry benchmark.

The Sharpe ratio's denominator in that example will be those monthly

returns' standard deviation, calculated as follows:

1. Take the return variance from the average return in each of the

incremental periods, square it, and sum the squares from all of the
incremental periods.
2. Divide the sum by the number of incremental time periods.
3. Take a square root of the quotient.

What the Sharpe Ratio Can Tell You

The Sharpe ratio is one of the most widely used methods for measuring
risk-adjusted relative returns. It compares a fund's historical or projected
returns relative to an investment benchmark with the historical or
expected variability of such returns.

The risk-free rate was initially used in the formula to denote an investor's
hypothetical minimal borrowing costs.1 More generally, it represents
the risk premium of an investment versus a safe asset such as a Treasury
bill or bond.

When benchmarked against the returns of an industry sector or investing

strategy, the Sharpe ratio provides a measure of risk-adjusted
performance not attributable to such affiliations.

The ratio is useful in determining to what degree excess historical returns

were accompanied by excess volatility. While excess returns are
measured in comparison with an investing benchmark, the standard
deviation formula gauges volatility based on the variance of returns from
their mean.

The ratio's utility relies on the assumption that the historical record of
relative risk-adjusted returns has at least some predictive value.1

 
Generally, the higher the Sharpe ratio, the more attractive the risk-adjusted
return.
The Sharpe ratio can be used to evaluate a portfolio’s risk-adjusted
performance. Alternatively, an investor could use a fund's return objective
to estimate its projected Sharpe ratio ex-ante.

The Sharpe ratio can help explain whether a portfolio's excess returns are
attributable to smart investment decisions or simply luck and risk.

For example, low-quality, highly speculative stocks can outperform blue

chip shares for considerable periods of time, as during the Dot-Com
Bubble or, more recently, the meme stocks frenzy. If a YouTuber happens
to beat Warren Buffett in the market for a while as a result, the Sharpe
ratio will provide a quick reality check by adjusting each manager's
performance for their portfolio's volatility.

The greater a portfolio's Sharpe ratio, the better its risk-adjusted

performance. A negative Sharpe ratio means the risk-free or benchmark
rate is greater than the portfolio’s historical or projected return, or else the
portfolio's return is expected to be negative.