Know more about Sharpe ratio

Sharpe ratio is the risk-adjusted return, which measures reward to variability. Firstly, a portfolio’s return in excess of the risk-free return is calculated and then this excess return is divided by the portfolio’s standard deviation. This ratio is named after William Sharpe. The Sharpe ratio is the simplest measure to compute, which is why it is the most widely used risk-adjusted return measure. 

The formula is: 

Sharpe ratio = (return of the portfolio - risk-free return)/standard deviation of return on the portfolio. 

It is to be noted that these three variables should be for the same period. Generally, for easy comparison across portfolios, annualised returns, as well as annualised standard deviation, are taken for computing the Sharpe ratio of the portfolio. 

For example, the annualised return for a portfolio is 11.50 per cent and the risk-free rates (on treasury notes) return is 6 per cent. The standard deviation of the same portfolio is 6.50 per cent. Then, 

Sharpe ratio = (11.5% – 6%) / 6.5% = 0.862 

Sharpe ratio is a measure of relative performance. It is one of the most useful tools for the selection of mutual funds, which enables investors to compare across investment opportunities. The higher the Sharpe ratio, the better is the portfolio’s risk-adjusted-performance. A fund with a higher Sharpe ratio in relation to another is preferable as it indicates that the fund has generated return for every unit of risk. 

As the Sharpe ratio adjusts return to the total portfolio risk, it is a useful measure of performance for several mutually exclusive portfolios. However, this ratio ignores the diversification potential of the portfolio.