How does the Sharpe Ratio work?
The Sharpe Ratio gives an investor an idea of how well the investments risk adjusted return compares to similar investments. The idea is to achieve the highest possible return with the least amount of risk. The Sharpe Ratio can tell you if the outperformance is due to well-performing investments, or if the investment has too much risk. Typically, when more risk is taken, more return is expected for taking that risk.
The formula for the Sharpe Ratio is: (Rate of Return – Risk free Rate) / Standard Deviation
Under what circumstances is it used?
The Sharpe Ratio can be used to compare similar investments in ETFs, Mutual Funds, and individual stocks. It can also be used to evaluate the risk adjusted return at the portfolio level. The greater a portfolio’s Sharpe Ratio, the more attractive its risk adjusted return. If you have two investments, one with a larger return and the other with a larger Sharpe Ratio, the investment with the larger Sharpe Ratio should be selected at the investment level. The investment with the larger Sharpe Ratio will improve the performance on a risk adjusted basis.
How is it tied to Modern Portfolio Theory?
Modern Portfolio Theory proposes that an investment’s risk and return are weighed by how they affect the overall portfolio. Rather than only looking at an investment’s risk/reward, Modern Portfolio Theory looks at the entire portfolio’s risk/reward. By being diversified and investing in uncorrelated investments, the investor has a better opportunity to increase the Sharpe Ratio when compared to a portfolio with less diversification. Modern Portfolio Theory believes that the return of one asset is less important than the larger portfolio. The Modern Portfolio Theory takes the Sharpe Ratio one step further by attempting to achieve the best risk adjusted return at the portfolio level instead of the individual investment.
How does the diversification of a portfolio affect the ratio?
Generally, the diversification of investments that are uncorrelated or move inversely will increase the Sharpe Ratio. Having investments within different asset classes further diversifies the overall portfolio and increases the Sharpe Ratio. By increasing the Sharpe Ratio, an investor can potentially achieve the same amount of return with less risk. If the investor decides to take the same risk, they could increase the expected return.
Downsides or any problems using the Sharpe Ratio?
When using any type of fundamental analysis, it is important to remember to use several tools to draw effective conclusions. The Sharpe Ratio is a great tool, but on its own it doesn’t tell you everything you need to know about the investment. Let’s review the three inputs in order to calculate the Sharpe Ratio. First, you have the rate of return. Using 1, 3, 5, and 10 years performance can change the entire rate of return. Next, you have the risk-free rate – today it is very low, but in years past this number was much higher. Finally, we have the standard deviation. Depending on the factor used, it can dramatically change the Sharpe Ratio. Some years, no matter how good an investment is, the standard deviation could be very high due to market conditions. The Sharpe Ratio is a great tool, but reviewing it with many other tools will provide the investor with a greater understanding of the investment history.
Portfolio Manager at Intercontinental Wealth Advisors