The Sharpe Ratio: Return Relative to Risk
A 20% return or a 10% return—which is the better investment? The Sharpe Ratio also weighs "how much risk did you take on."
What Is the Sharpe Ratio
The Sharpe Ratio is a metric that measures excess return per unit of risk.
Formula: Sharpe Ratio = (portfolio return − risk-free return) / portfolio volatility (standard deviation)
The risk-free return generally uses the short-term government bond rate.
Example: Fund A: return 20%, volatility 30%, risk-free return 3% → Sharpe = (20−3)/30 = 0.57 Fund B: return 12%, volatility 10%, risk-free return 3% → Sharpe = (12−3)/10 = 0.90
A has the higher absolute return, but B has the higher return relative to the risk taken.
How to Interpret the Sharpe Ratio
Common Sharpe Ratio interpretation guidelines: 1.0 or higher: excellent — good return for the risk 0.5–1.0: good — the level of a typical diversified portfolio 0–0.5: fair — the return may not be enough for the risk Below 0: poor — a result worse than a risk-free asset
Historically, the long-term Sharpe Ratio of the U.S. S&P 500 has been around 0.4–0.6. A well-diversified 60/40 portfolio targets around 0.5–0.8.
The Sharpe Ratio assumes a normal distribution. It has the limitation of not capturing extreme loss risk (tail risk) well.
The Limits of the Sharpe Ratio
There are limits to evaluating an investment by the Sharpe Ratio alone.
1. It assumes volatility = risk: it treats upside volatility (surging gains) and downside volatility (plunging losses) as equal. In reality, investors dislike only the downside. (The Sortino Ratio was created to address this.)
2. Period dependence: the Sharpe Ratio changes greatly depending on the measurement period. A calculation for 2019 and one including the 2020 pandemic are entirely different.
3. No absolute standard: whether a 0.5 is "good" can only be known by comparing against a benchmark.
Preguntas frecuentes
Q. Is a high Sharpe Ratio always a good investment?
A higher value means the return is more efficient relative to risk, but there is no absolute standard. Also, the Sharpe Ratio is calculated from past data, so it does not guarantee future performance. It is best used together with other risk metrics such as maximum drawdown (MDD) and the longest drawdown duration.
Q. What is the Sortino Ratio?
The Sortino Ratio is a variant of the Sharpe Ratio that uses only downside volatility (movements in the loss direction only) instead of total volatility. The logic is that upside volatility is not bad for the investor. Formula: (return − target return) / downside standard deviation. Some argue it is more intuitive from the investor's perspective than the Sharpe Ratio.
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📋 Los resultados se basan en datos históricos; las rentabilidades pasadas no garantizan rentabilidades futuras.
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