The Sharpe ratio is a very simple measure of assessing the benefit of an investment. It aims to calculate the excess return, which is the return which is achieved above and beyond that which would have been attained from simply tracking the market as a whole. This return is then considered in terms of the risk which had been involved. While the simplicity of the Sharpe ratio is its major benefit, it can also be a weakness.
Somebody analyzing an investment will often use the Sharpe ratio to assess risk vs return. The balance between the potential or expected return on investment and the risk that the actual return will be lower, or even negative, is a major factor in most investment decisions. To make this assessment properly, the return needs to be assessed within the context of other options. Most notably, the return of a particular investment should be compared with the amount of risk associated with the investment.
The Sharpe ratio is one way to do this. In its simplest form, the ratio is the differential return divided by the standard deviation. In turn, the differential return is the return on the portfolio minus the return on the benchmark. These concepts are all much simpler than their names may suggest.
The return on the portfolio is the return on the investment being assessed, expressed as a percentage. The return on the benchmark can be calculated in two ways. One is to compare it to an equivalent investment with effectively no risk, such as a government issued debt. Another method is to compare it to the performance of an entire related market. For example, when assessing an individual stock, the benchmark could be a related stock market index. The former method is sometimes known as the original Sharpe ratio, while the latter is known as the generalized Sharpe ratio or the information ratio.
The standard deviation is a measure comparing how much an investment's performance has varied in comparison to that of the entire market. Rather than simply comparing its final level, this measure looks at the total range of movement over time of an investment's value. This is usually taken as an indicator of how much risk is involved in the investment: the more it varies, the greater the potential for both gains and losses.
By applying the Sharpe ratio, it's possible to produce what is known as a risk-adjusted return. This shows how well an investment performed in comparison to the level of risk taken. This can be an indicator of the skills of an investor of fund manager. For example, one fund manager may have achieved a higher return over the past year than a rival. If the rival has a higher Sharpe ratio, it may indicate that the first manager simply got lucky with their investments and the rival is a better bet for balancing risk vs return in the future.
It's possible to use the Sharpe ratio either retrospectively or as a forecast. Applying it to historical data is known as an ex post calculation. Applying it to forecasts is an ex ante calculation.
