Sharpe Ratio vs. Other Investment Metrics
What Is the Sharpe Ratio?
The Sharpe Ratio (also known as the reward-to-variability ratio) measures the difference between the returns of an investment and the risk that was taken. In summary, it seeks to determine how valuable an investment was (via returns), and if it sufficiently compensates the amount of risk that was taken.
The Sharpe Ratio Formula
The Sharpe Ratio formula was first developed in 1966, and looks like this: Sharpe Ratio = E(Ra - Rb) / σa
The “E” represents your investments’ expected value, the “Ra” represents asset return, and the “Rb” represents the risk free return.
The “σa” represents the standard deviation of the asset excess return. Standard deviation shows how much an investment's returns fluctuate over time, based on all the returns in the period you're looking at.
The higher the ratio, the more return you’re earning for each unit of risk. A Sharpe Ratio of 1.0 or more is typically considered good, but a Sharpe Ratio of 2.0 or 3.0 is even better. A Sharpe Ratio 0.90 or below might indicate the risk outweighs the return of an investment.
Sharpe Ratio: Pros & Cons
Pros
The Sharpe Ratio is straight-forward and generally easy-to-understand.
It’s a good formula for comparing different investments, helping you understand the overall risk of your portfolio.
It accounts for risk, which is incredibly important for identifying high-risk investments that aren’t as rewarding as they should be.
With the risk-free rate, you can compare the performance of high-risk investments to low-risk investments, like treasury bonds.
Cons
The Sharpe Ratio depends on the assumption that returns are normally distributed in a bell curve, but this isn’t usually the case for the real-world market.
The formula treats all volatility as bad, but some volatilities are good. Additionally, some investors will accept short-term volatility strategically because it offers long-term gains.
It’s not comprehensive for risk management since it doesn’t predict market crashes or other cases of rare loss.
Alternatives for Sharpe Ratio: Other Investment Metrics
Sortino Ratio
The Sortino Ratio slightly modifies the original Sharpe Ratio. It is another way to measure the risk-adjusted return of an investment, but unlike Sharpe Ratio, only returns that don’t meet rate of return expectations negatively impact the ratio. This means that it only considers downward volatility and not upward volatility (which can have a positive impact on investments).
The formula looks like this: Sortino Ratio = (Rp - Rf) / Downside Deviation
Treynor Ratio
The Treynor Ratio (also known as the reward-to-volatility ratio) focuses on systematic risk, which is the risk inherent to the entire market, rather than total risk. By considering only the negative impact of market movements, the Treynor Ratio offers a more refined approach for investors seeking to assess performance relative to market volatility.
The formula for the Treynor Ratio is as follows: Treynor Ratio = (Rp - Rf) / Beta, where Rp is the expected return of the portfolio, Rf is the risk-free rate, and Beta represents the portfolio's sensitivity to market movements.
Want to Make Smarter Investment Choices?
Key metrics like the Sharpe Ratio are a great way to help you make better investment decisions. If you want investment advice you can rely on, look no further than GRFS investment planning.
Our investment planners can help you develop a diversified portfolio that meets your financial goals while staying within your desired risk level. We provide comprehensive risk assessment and realistic forecasting, so you can feel confident in where your money goes.
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