Using the Sharpe Ratio to Compare Risk-Adjusted Portfolio Returns

Summary

The document explains the Sharpe ratio as portfolio excess return over a risk-free rate divided by portfolio return volatility. It identifies the portfolio return, risk-free rate, and standard deviation as the inputs, with short-term government debt offered as a possible proxy for the risk-free rate. Two worked examples illustrate the calculation: one reports a ratio of about 1.14, and another gives 0.5. The article also presents the ratio as a way to compare portfolios and monitor the balance between risk and return.

It offers rough interpretive bands, treating negative values as weak excess performance and values above two as potentially attractive but deserving scrutiny. These thresholds are general guidance rather than universal standards. The article cautions that unusually high readings may reflect unusual market conditions, calculation errors, or understated risk. It does not discuss estimation choices such as return frequency, sample length, or the limitations of standard deviation as a measure of risk, so the ratio should not be read as a complete assessment of a portfolio.

Key ideas

• The Sharpe ratio divides portfolio excess return by portfolio return volatility.
• The risk-free rate can be represented by a short-term government borrowing rate.
• A higher ratio indicates more excess return per unit of measured volatility, all else equal.
• Very high readings should be checked for unusual conditions, data errors, or understated risk.
• The document gives general interpretation bands but does not address estimation choices or alternative risk measures.

Tags

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.