Sharpe ratio

Definition

The Sharpe ratio measures the performance of an investment compared to a risk-free asset, after adjusting for its risk. It is calculated by subtracting the risk-free rate from the investment return and then dividing the result by the standard deviation of the investment's excess return.

5 Must Know Facts For Your Next Test

1. The Sharpe ratio helps determine how much excess return you receive for the extra volatility endured by holding a riskier asset.
2. A higher Sharpe ratio indicates a more attractive risk-adjusted return.
3. If the Sharpe ratio is less than one, it generally indicates that the investment has not performed well on a risk-adjusted basis.
4. The formula for calculating the Sharpe ratio is (Rp - Rf) / σp, where Rp is the return of the portfolio, Rf is the risk-free rate, and σp is the standard deviation of portfolio returns.
5. It assumes that returns are normally distributed and may not be as reliable for investments with asymmetric returns.

Review Questions

• What does a higher Sharpe ratio signify in terms of investment performance?
• How do you calculate the Sharpe ratio?
• Why might a Sharpe ratio below one be concerning?

Related terms

Standard Deviation: A statistical measure of market volatility, indicating how much an asset's price deviates from its average over time.

Risk-Free Rate: The theoretical rate of return on an investment with zero risk, typically represented by government bonds.

Alpha: A measure of an investment's performance on a risk-adjusted basis relative to a benchmark index.