Sharpe Ratio

The Sharpe Ratio is very handy for making quick decisions when comparing investment funds but has to be used with care.

Sharpe Ratio Calculator

	Investment Fund #1	Investment Fund #2
Return of the investment fund	%	%
Return on cash	%	%
Volatility	%	%
Sharpe Ratio	calculated	calculated

To calculate the Sharpe Ratio the following values are required:

• Return of the investment fund over a given period (e.g. 13% over twelve months)
• Return from a bank on cash over the same period (e.g. 4.5%)
• Volatility or risk of the fund over the same period. This is the standard deviation. (e.g. 10%)

The return you could have had from the bank is called the "Risk Free Rate". If the "Risk Free Rate" is subtracted from the fund's return we get the "Risk Premium" - the extra reward for tolerating risk. When the "Risk Premium" is divided by the Risk the result is the Sharpe Ratio.

Worked Examples

Investment Fund 1

Fund 1 has a return of 13% when cash would have returned 4.5% during which time the fund had a volatility of 10%.

The Sharpe Ratio would be (13%-4.5%)/10% which gives 0.95 for this fund.

Investment Fund 2

Fund 2 has a return of 13% when cash would have returned 4.5% during which time the fund had a volatility of 5%.

The Sharpe Ratio would be (13%-4.5%)/5% which gives 1.90 for this fund.

Comparing Investment Funds 1 and 2

As both funds, in this example, generated a return of 13%, the Sharpe Ratio indicates that Investment Fund 2 (the larger ratio) is more efficient at generating returns than Investment Fund 1. Logically, investors would prefer to earn their 13% in the lower risk fund - that is, the fund with a higher Sharpe Ratio.

More Information

I will add more in due course, but you can find a little more at The Motley Fool.