What Is A Good Sharpe Ratio: Talk to your parents and friends about investing, and the first thing they do is tell you to buy land, accumulate gold, and start a long-term FD. That has always been their version of investments in the long term – Safe, assured, and tangible.
And if you further try to convince them to invest in stocks, their one question is – Can you guarantee that the investment will perform better than gold, land, and bank deposits?
While they didn’t know it, they were actually using the Sharpe ratio in a different form. So what is the Sharpe Ratio? And what is a good Sharpe Ratio?
Who came up with this ratio? We’ll answer all these questions, adding to how important it is and how you can use it as well.
Who Is William F. Sharpe?
The Sharpe Ratio was created by William Forsythe Sharpe, a nobel-award winning economist. He is also credited with the creation of the capital asset pricing model in the 1960s.
The CAPM model describes the connection between systematic risk and expected returns, adding that higher risk is needed to gain higher profits. It’s mostly used in portfolio management, where it is a very important concept.
Sharpe graduated from the University of California in L.A., with a bachelor’s degree in arts (1955), and a master’s degree in arts (1956). He completed his Ph.D. in economics in 1961.
Sharpe had a career in academics, consulting, and economics, working with big names in the industry such as the University of Washington, Stanford University, RAND corporation, Merrill Lynch, and Wells Fargo.
He was also the founder of Sharpe-Russell Research and William F. Sharpe Associates. William F. Sharpe won his Nobel prize in economics in 1990, for his CAPM model. The Sharpe ratio is based on the CAPM model.
What Is Sharpe Ratio?
At the beginning of this article, we spoke about how conservative investors often use the most secure investments as a metric to compare every other investment like stocks.
The Sharpe ratio is a well-known measure of risk-adjusted returns from an investment. It’s used to either compare an individual stock, or an investment portfolio itself.
Compared to what, you might ask. Well, it is compared to the returns from the safest form of investment. Given the fact that William Sharpe was an American, their safest investment is the American T-bills.
While some might argue that the comparison of a T-bill, which has the shortest maturity, to equities is not fair. This is because the length of time doesn’t necessarily match the safest investment.
How To Calculate The Sharpe Ratio?
William Sharpe’s ratio was made in the year 1966 and has been one of the most used metrics for checking risk to return in the markets. The reason is mainly because of how easy it is to understand. When Sharpe won the Nobel prize in 1990 for the CAPM, it further boosted the credibility of the ratio he created.
To calculate the Sharpe Ratio, you need to first calculate the expected rate of return of the stock or the portfolio, minus the risk-free rate of return. The figure that you get by doing this should be divided by the standard deviation of the stock or portfolio.
Let’s understand with an example –
Imagine a stock TSLA has an expected rate of return of 25 percent. The risk-free rate is around 2.5 percent and the standard deviation is 10 percent.
Taking these assumptions into account, the Sharpe ratio can be calculated as :
25 – 2.5 / 10 = 2.25
This stock has a Sharpe ratio of 2.25, which is considered very good.
Formula Of Good Sharpe Ratio
Sharpe Ratio = (Rp – Rf) / σp
Where
Rp = Return Of Portfolio
Rf = Risk-Free Rate
σp = Standard Deviation Of The Portfolio’s excess return
The Metrics Of Sharpe Ratio: What Is A Good Sharpe Ratio?
In the previous example, we calculated the Sharpe ratio of a stock using certain assumptions. The figure we got, as a result, told us what to expect from the stock.
But how do we come to that conclusion? To understand what is a good Sharpe ratio, you need to know what each number would represent –
- A Sharpe ratio below 1 is considered below average.
- Above 1 is acceptable or good
- A ratio above 2 is considered very good
- The above 3 is considered an excellent Sharpe ratio.
Importance Of Sharpe Ratio
The Sharpe ratio is important for a lot of reasons, specifically in mutual funds where investors need to recognize the risk level and adjusted rate of return. Investors need to know if they will reap high returns by taking a higher risk on their investments.
- Benchmark For Returns
The Sharpe ratio sets a benchmark for what to expect from an asset, either current or future investments. This gives investors an idea of what to expect when comparing peer investments, be it stocks or mutual funds.
- Study Risk And Rate Of Return
The Sharpe ratio is used to show investments with higher returns as well as higher risk. Investors might tend to forget, but assets with a high Sharpe ratio come with a greater risk.
Add volatility to the mix, and investors would rather invest in assets with lower volatility and moderate returns over high volatility, and high returns.
Downsides Of The Sharpe Ratio
The Sharpe ratio comes with its own downsides, as written below:
- It does not take into account the portfolio risk and if a fund considers one or more factors.
- It assumes all investments have a normal pattern of return dispersion, which might not be the case with every fund.
- Comparing funds using the Sharpe ratio only shows the risk-adjusted rate of return.
- The ratio is susceptible to manipulation by portfolio managers, by increasing the time horizon of investment to boost risk-adjusted returns. By evaluating a mutual fund using just the Sharpe ratio, you might not be able to get the full idea.
Also Read: Significance Of Current Ratio – Formula & Examples Explained!
In Closing
William Sharpe’s creation of the Sharpe ratio has added immense value to financial markets. It makes studying and comparing assets all the easier.
It does have a few downsides, but its simplicity makes it easy and convenient for every investor to understand. We hope you understand and got the answer to your question “What Is A Good Sharpe Ratio?” Happy Investing!
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