Formula to Calculate Sharpe Ratio
Sharpe ratio formula is used by the investors in order to calculate the excess return over the risk-free return, per unit of the volatility of the portfolio and according to the formula risk-free rate of the return is subtracted from the expected portfolio return and the resultant is divided by the standard deviation of the portfolio.
Where,
- Rp = Return of portfolio
- Rf = Risk-free rate
- σp = Standard deviation of the portfolio’s excess return.
How to Calculate Sharpe Ratio?
- The Sharpe ratio is calculated by dividing the difference of return of the portfolio and risk-free rate by Standard deviation of the portfolio’s excess return. Through this, we can evaluate the investment performance based on the risk-free return.
- Higher Sharpe metric is always better than a lower one because a higher ratio indicates that the portfolio is making a better investment decision.
- The Sharpe ratio also helps to explain whether portfolio excess returns are due to a good investment decision or a result of too much risk. As higher the risk higher return, lower the risk lowers the return.
- If one of a portfolio has a higher return than that of its competitors then it’s a good investment as a return is high and risk is the same. It’s about maximizing returns and reducing volatility. If any investment has a rate of return 15% and volatility are zero. Then Sharpe ratio will be infinite. As volatility increases, the risk significantly goes up as a result rate of return also increases.
Let us see the grading threshold of the Sharpe ratio.
- <1 – Not good
- 1-1.99 – Ok
- 2-2.99 – Really good
- >3 – Exceptional
Portfolio with zero risks like only Treasury bill, as an investment is risk-free there is no volatility and no earnings in excess of the risk-free rate. Thus, the Sharpe ratio has zero portfolios.
- A metric 1, 2, 3 have a high rate of risk. If the metric is above or equal to 3 it is considered as great Sharpe measurement and a good investment.
- Whereas is metric of between greater or equal to 1 and 2 less than 2, it is considered to just ok and if a metric is between greater than or equal to 2 and less than 3 than it is considered that it is really good.
- If a metric is less than 1 then it is not considered as good.
Examples
Example #1
Suppose, there are two mutual funds to compare with different portfolios having different risk levels. Now let us see the Sharpe ratio to see which one is better performing.
Investment of Mid Cap Fund and details are as follows:-
- Portfolio return = 35%
- Risk free rate = 15%
- Standard Deviation = 15
So the calculation of Sharpe Ratio will be as follows-
- Sharpe Ratio Equation = (35-10) / 15
- Sharpe Ratio = 1.33
Investment of Bluechip Fund and details are as follows:-
- Portfolio return = 30%
- Risk free rate = 10%
- Standard Deviation = 5
So the calculation of Sharpe Ratio will be as follows-
- Sharpe Ratio = (30-10) / 5
- Sharpe Ratio = 4
Therefore the Sharpe ratios of an above mutual fund are as below-
- Bluechip Fund = 4
- Mid Cap fund = 1.33
The bluechip mutual fund outperformed Mid cap mutual fund but it does not mean that Mid cap mutual fund performed well relative to its risk level. The Sharpe tell us below things:-
- Bluechip mutual fund performed better than Mid cap mutual fund relative to the risk involved in the investment.
- If Mid cap mutual fund performed as well as the Bluechip mutual fund relative to risk, it would earn a higher return.
- The bluechip mutual fund has earner higher return this year but as risk is high. Hence, it will have high volatility in the future.
Example #2
Here, one investor is holding a $5,00,000 invested portfolio with an expected rate of return of 12%, and a volatility of 10%. The efficient portfolio expects a return above 17% and a volatility of 12%. The risk-free interest is 4%. The calculation of the Sharpe ratio can be done as below:-
- Sharpe ratio = (0.12 – 0.04) / 0.10
- Sharpe ratio = 0.80
Sharpe Ratio Calculator
You can use the following Sharpe Ratio Calculator.
| Return of Portfolio | |
| Risk Free Rate | |
| Standard Deviation of Portfolio's Excess Return | |
| Sharp Ratio Formula = | |
| Sharp Ratio Formula = |
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Advantages
Advantages of the Sharpe ratio are as follows:-
- The ratio is the average return earned in excess of the risk-free rate per unit volatility or total risk
- Sharpe ratio helps in comparisons of investment.
- Sharpe ratio helps in risk-return comparisons.
There are some issues while using the Sharpe ratio that it is calculated in an assumption that investment returns are normally distributed and that is resulting in relevant interpretations of Sharpe ratio to be misguiding.
Sharpe Ratio Calculation in Excel
In the below-given template is the data for the Mid Cap Mutual Funds and Bluechip Mutual Funds for the calculation of the Sharpe ratio.
In the below given excel template, we have used the calculation of the Sharpe ratio equation to find the Sharpe ratio.
So the calculation of Sharpe Ratio will be-
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This has been a guide to Sharpe Ratio Formula. Here we discuss how the investors use this formula to understand the return on investment compared to risk on it along with practical examples and Calculator. You can learn more about Portfolio Management from the following articles –
