Sharpe Ratio

There are lots of metrics that we can use to understand the performance of our investments and one which you may hear your wealth managers frequently talk about, or see in reports, is the Sharpe ratio.

This eponymously named metric was developed by Nobel prize-winning American economist William F Sharpe back in the 1960s so that investors could better appreciate the risk-adjusted return on investments or, to put it more simply, whether the rewards (i.e. gains) from holding a particular asset merit the level of additional risk taken on in buying it.

The “additional” part is crucial here as the Sharpe ratio compares holding a risk asset like a stock to a relatively risk-free asset like a short-term government bond. This way, the investor can zero in on whether the additional risk was, in fact, worth it.

The Sharpe ratio is calculated by taking the risk-free rate of return away from that of the risk asset – or indeed a whole portfolio – and then dividing this figure by the standard deviation of that security or portfolio’s additional return (don’t worry, this calculation will be presented by a wealth manager to you in your investment reporting; you don’t have to crunch the numbers yourself). Typically, the higher the resulting figure, the more attractive the investment is.

You can use the Sharpe ratio to assess investments on a forward-looking basis using expected returns to help decide whether they are a good idea compared to something safer, or it can be used on a backwards-looking basis to unpack what exactly has driven your returns and whether too much risk has been taken to secure only a modest result, for instance. It is not, however, necessarily applicable to all investments as it relies heavily on volatility being a measure of risk, and the picture might be more complex than that for some elements of your portfolio.