Learn how to calculate the Sharpe ratio to gauge risk, compare investments, and make informed decisions based on risk-adjusted returns in your portfolio.
You’re evaluating potential investments, and you’ve narrowed it down to two choices with similarly attractive returns. Each has similar expense ratios, roughly the same market price, and in the case of mutual funds or exchange-traded finds, similar holdings.
But which one could potentially be the better choice? To decide, consider looking at risk using a fundamental analysis tool called the Sharpe ratio—one of the most widely used calculations for measuring risk-adjusted returns. You’ll see it most frequently used in the fund industry, but it can be applied to any investment.
The Sharpe ratio, created by Nobel Laureate William F. Sharpe in 1966, helps investors evaluate a particular asset’s volatility so they can identify which investment might provide the best returns based on their risk tolerance.
“The Sharpe ratio is a useful tool for investors who want to balance risk and return. It’s a relatively simple calculation anyone can use to compare two investment choices,” explained Nick Theodorakos, managing director, financial risk management at Charles Schwab.
While it’s a solid addition to any investor’s technical analysis toolbox, particularly those starting out, it’s far from a “silver bullet for a successful investment,” Theodorakos explained, adding, “investors need to dig deeper into a portfolio to learn more about how the investments are being managed and whether leverage is being used.” This is important because leverage amplifies both gains and losses.
Individual investors can use either forecasted returns or historical data to calculate the Sharpe ratio. Forecasted data can be subjective—an inherent flaw—that can result in a less-reliable Sharpe ratio compared to what historical returns and volatility data can tell you. However, it’s important to understand past or forecasted performance is not a guarantee of future performance—all investing carries the risk of loss.
Here’s the Sharpe ratio formula:
Sharpe ratio = (Rp – Rf) ÷ Standard deviation
The Sharpe ratio can help investors evaluate stocks, ETFs, or mutual funds. Many investors favor a lower-risk asset with a duration similar to their intended time horizon for the investment. One example might be using a 5-year Treasury note for an investment with a planned holding time of around five years, while a 1-year T-bill could be used as the risk-free rate for one that’s shorter term.
Referring to the Federal Reserve’s historic series of rate hikes in 2022–23, Theodorakos added, “you need to be aware of what lower-risk asset is being used in the calculation to gain a better insight into the resulting Sharpe ratio and to recognize the changes in lower-risk yields over time.”
Most investments fall into the 1.00–1.99 range, while readings above 2.0 could suggest the use of leverage to boost returns and, with it, risk. (Remember, leverage amplifies both gains and losses.) It’s a sign you may want to investigate the investment further.
A negative Sharpe ratio indicates the investment performance or the fund manager’s returns did not exceed the risk-free rate and potentially lost money during the time frame you’re analyzing. If your calculations are in the red, consider evaluating the ratio on similar assets or funds. If the asset you’re considering and its peers are all negative, perhaps that asset or sector suffered a broad-based period of weakness that took all the funds in the category down. That might encourage you to take a closer look at the sector as a whole.
Like all statistical measures, the Sharpe ratio has limitations:
Even with its limitations, the Sharpe ratio is still a solid place to start for investors seeking an investment with an attractive risk/reward profile. It can be used to compare the relative risk/reward of different investments, allowing investors to find the highest return in line with their level of risk tolerance. When used to measure a fund’s returns, this ratio can also measure the performance of the fund manager relative to a chosen risk-free rate. Investors can evaluate the Sharpe ratio of a particular investment on thinkorswim paperMoney® before making a purchase; it just requires a moment to set up.
If you’re interesting in learning about other key portfolio return measures and what they mean for your portfolio, check out the Information ratio and Sortino ratio.
The Sharpe ratio is not included on the regular menu of technical studies available on thinkorswim. But you can add it by following these steps:
To apply the Sharpe ratio to a thinkorswim chart, select the Charts tab, then Edit studies (middle beaker symbol). From the Edit Studies and Strategies window, start typing Sharpe ratio in the blank field and a list will populate.
Select Sharpe ratio from the list, then Add selected, and it will appear on the right. Select OK, and the Sharpe ratio will appear at the bottom of your chart.
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