Reviewed by Oct 05, 2020| Updated on
The Nobel laureate, William F. Sharpe developed the Sharpe ratio, and it is used to help investors understand an investment return and the risk. The ratio reflects the average return received above the risk-free rate per unit of uncertainty or total risk.
Volatility is one indicator of an asset or portfolio's price fluctuations. Reducing the risk-free rate from the mean return helps an investor to separate the income of risk-taking behaviours better. The risk-free return rate is the return on a zero-risk investment, meaning it could be assumed by return investors to take no risk.
Formula and Calculation of 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 Formula explained: 1. Deduct risk-free rate from portfolio return. 2. Divide the result by the standard deviation of the excess return for the portfolio. 3. The standard deviation helps demonstrate how much return for the portfolio deviates from the anticipated return. The standard deviation sheds light on the volatility of the portfolio, too.
The Sharpe ratio has been the most commonly used tool for the risk-adjusted return calculation. The modern theory of portfolios states that adding assets to a diversified portfolio with low correlations will reduce portfolio risk without losing return. The Sharpe ratio will also help to clarify whether the excess returns of a portfolio are due to wise investment decisions or too much risk.
The higher the Sharpe ratio of a portfolio, the greater its risk-adjusted-performance. When the analysis results in a negative Sharpe ratio, it either means that the risk-free rate is higher than the return from the portfolio, or it is assumed that the return from the portfolio is negative. A negative Sharpe ratio, in any case, conveys no useful significance.