What is a Good Sharpe Ratio? Insights for Better Investing

What is a good Sharpe ratio?

Imagine you have two investment options. Option A yields 8% in annual return with a 10% standard deviation. Option B offers a 6% yearly return and a 5% volatility. Which of these investment choices has a higher risk-adjusted return?

Answer: You can’t respond to that question using only average values. Why? The alternatives also differ in terms of the variance of the returns from the mean. The Sharpe ratio tells investors how much investment returns with the associated risk they may expect.

According to research, the Sharpe ratio of American shares has averaged about 0.35 over the last 50 years. The American bonds’ standard Sharpe ratio has been about 0.50 for the same period.

This situation raises the query: What is a good Sharpe ratio?

The key is understanding that a greater Sharpe ratio signifies superior performance when considering risk. In our example, the second investment choice is more appealing. Why? It has a higher Sharpe ratio, signifying a higher return when adjusted for risk.

This blog post explains the Sharpe ratio in simple terms. We will examine real-life cases and key factors for investors looking to make knowledgeable choices.

Table of Contents:

1. What is the Sharpe Ratio?
2. What Does the Sharpe Ratio Mean?
3. What Does the Sharpe Ratio Measure?
4. How to Calculate the Sharpe Ratio?
5. What are the Limitations of the Sharpe Ratio?
6. How to Examine the Sharpe Ratio?
7. Wrap Up

First…

What is the Sharpe Ratio?

Definition: The Sharpe ratio is a measure of risk-adjusted return. It helps investors understand how much return they receive for the risk they take.

In 1966, economist William F. Sharpe introduced the Sharpe ratio based on his research on the CAPM model. He referred to it as the reward-to-variability ratio. Sharpe was awarded the Nobel Prize in economics for his contributions to the CAPM in 1990.

The formula of the Sharpe ratio is simple:

Subtract the risk-free rate from the investment return. Then, divide the result by the standard deviation of the investment’s return. The risk-free rate is typically a Treasury bond rate.

A higher Sharpe ratio indicates better risk-adjusted performance. This means that the investment provides higher returns for each unit of risk. Conversely, a lower Sharpe ratio suggests less favorable risk-adjusted returns.

This ratio is crucial for comparing investments. It helps investors choose assets with the best return for the least risk. It is commonly used for mutual funds, portfolios, and individual securities.

The Sharpe ratio is a key tool for assessing investment performance. It balances return against risk, guiding better investment decisions.

What Does the Sharpe Ratio Mean?

Definition: The Sharpe ratio assesses the return adjusted for risk. It measures the additional gain of an investment (or portfolio) relative to the risk (standard deviation). A high Sharpe ratio signifies improved performance when adjusting for risk, showcasing increased returns for the same risk level. Or decreased risk for the same level of returns.

Below, you can learn what the Sharpe ratio measures.

What Does the Sharpe Ratio Measure?

The Sharpe ratio provides valuable insights into how well an investment compensates investors for the risk taken. Here are the five main aspects it measures:

• Risk-adjusted return: The Sharpe ratio assesses how much excess return an investment generates per unit of risk. This helps investors understand if the returns justify the risk.
• Performance comparison: It enables comparing how well various investments perform, regardless of their varying risk levels. Higher Sharpe ratios demonstrate improved performance when accounting for risk.
• Volatility impact: By factoring in the standard deviation of returns, the Sharpe ratio highlights the impact of volatility on an investment’s returns. Lower volatility typically leads to a higher Sharpe ratio.
• Excess return over risk-free rate: The ratio considers the difference between the investment return and the risk-free rate, usually represented by government bonds. This highlights the additional return earned for taking on risk.
• Investment efficiency measures an investment’s efficiency in converting risk into returns. A higher Sharpe ratio indicates that an investment is effectively using the risk taken to generate returns.

How to Calculate the Sharpe Ratio?

Calculating the Sharpe ratio is essential for assessing the risk-adjusted return of an investment. This ratio helps investors determine whether the returns of an investment compensate adequately for the risk taken. Here’s a step-by-step guide on how to calculate the Sharpe ratio:

1. Gather data: First, collect the necessary data. You need the investment’s average return, the risk-free rate (), and the standard deviation () of the investment’s returns.

• • The average return can be obtained from historical performance data.
  • The risk-free rate () is typically the yield on government bonds, such as U.S. Treasury bonds.
  • The standard deviation () measures the investment’s volatility.

2. Calculate excess return: Next, calculate the excess return. Deduct the risk-free rate () from the anticipated return of the investment or portfolio (). The formula is:

          Excess Return=−

          This step isolates the additional return earned over a risk-free investment.

3. Calculate Sharpe ratio: Now, calculate the Sharpe Ratio. The formula of the Sharpe ratio is:

4. Interpret the result: What is a good Sharpe ratio?

• • A higher Sharpe ratio indicates better risk-adjusted performance, meaning the investment provides higher returns for each unit of risk.
  • A lower Sharpe ratio suggests that the returns do not sufficiently compensate for the risk taken.

          Typically, a Sharpe ratio above 1 is considered acceptable, above 2 is considered good, and above 3 is considered

          excellent.

What are the Limitations of the Sharpe Ratio?

The Sharpe ratio is widely used for evaluating risk-adjusted returns. However, it has several limitations that investors should be aware of. Understanding these limitations helps in making more informed investment decisions.

• Relying on historical data: The Sharpe ratio depends on historical return information. Previous performance may not be a reliable indicator of future outcomes. This potentially causes miscalculations when assessing an investment’s risk and return potential.
• Assumption of normal distribution: The Sharpe ratio assumes that returns follow a normal distribution. However, several investments, particularly those that deal with derivatives or emerging markets, demonstrate non-normal distributions. This can affect the ratio’s accuracy.
• Sensitivity to benchmark choice: The chosen risk-free rate can significantly influence the Sharpe ratio. This is often a Treasury bond yield, highlighting the importance of benchmark selection sensitivity. Using an inaccurate or inconsistent benchmark may result in misleading outcomes.
• Volatility as a proxy for risk: The Sharpe ratio uses standard deviation to measure risk, considering volatility as a stand-in for risk. Nevertheless, not every instance of volatility is harmful. A portion could be advantageous (upside risk), leading to a misrepresentation of the actual risk.
• Not suitable for non-normal distributions: Investments with returns that exhibit skewness (asymmetry) or kurtosis (fat tails) can render the Sharpe ratio ineffective. Why? It does not account for these factors.
• Impact of skewness and kurtosis: Skewness and kurtosis in return distributions can distort the Sharpe ratio. This makes it less reliable for investments with significant deviations from normality.
• Sensitivity to time horizon: The Sharpe ratio may greatly differ based on the examined timeframe. Short-term data could indicate varying risk-return profiles compared to long-term data, resulting in conflicting evaluations.
• Assumption of constant risk-free rate: The ratio assumes a constant risk-free rate over the analysis period. In reality, this rate can fluctuate, affecting the calculation and interpretation of the Sharpe ratio.
• Focus on volatility alone: The Sharpe ratio overlooks other significant risks affecting investment returns. Such factors include:
  • Credit risk
  • Liquidity risk
  • Market risk
• Comparative constraints: The Sharpe ratio is beneficial for comparing investments, but solely among investments in the same asset class. Comparing ratios between asset classes might not offer valuable insights because of varying risk-return profiles.

How to Examine the Sharpe Ratio?

Data analysis often feels like exploring a jungle of numbers and statistics – easy to get lost in.

Enter the Sharpe ratio, a vital tool for investment assessment. But deciphering it requires more than just staring at spreadsheets; it demands the magic of data visualization.

While Excel is a trusty companion, it lacks the advanced visualizations necessary for Sharpe ratio analysis. Fear not, for ChartExpo emerges as the ultimate guide. Its powerful data visualization capabilities lead you through the dense wilderness of data.

Let’s learn how to install ChartExpo in Excel.

1. Open your Excel application.
2. Open the worksheet and click the “Insert” menu.
3. You’ll see the “My Apps” option.
4. In the Office Add-ins window, click “Store” and search for ChartExpo on my Apps Store.
5. Click the “Add” button to install ChartExpo in your Excel.

ChartExpo charts are available both in Google Sheets and Microsoft Excel. Please use the following CTAs to install the tool of your choice and create beautiful visualizations with a few clicks in your favorite tool.

Example

Let’s analyze the Sharpe ratio example data below using ChartExpo

Asset Class	Sharpe Ratio
Stocks	0.8
Stocks	0.9
Stocks	1.1
Stocks	1.2
Stocks	0.7
Bonds	0.5
Bonds	0.6
Bonds	0.7
Bonds	0.4
Bonds	0.3
Real Estate	0.6
Real Estate	0.7
Real Estate	0.8
Real Estate	0.9
Real Estate	1
Commodities	0.4
Commodities	0.5
Commodities	0.6
Commodities	0.7
Commodities	0.8
Cryptocurrency	0.7
Cryptocurrency	0.75
Cryptocurrency	0.78
Cryptocurrency	0.88
Cryptocurrency	0.82

• To get started with ChartExpo, install ChartExpo in Excel.
• Now Click on My Apps from the INSERT menu.

• Choose ChartExpo from My Apps, then click Insert.

• Once it loads, choose the “Box and Whisker Column Chart” from the charts list.

• Click the “Create Chart From Selection” button after selecting the data from the sheet, as shown.

• ChartExpo will generate the visualization below for you.

• If you want to have the chart’s title, click Edit Chart, as shown in the above image.
• Click the pencil icon next to the Chart Header to change the title.
• It will open the properties dialog. Under the Text section, you can add a heading in Line 1 and enable Show.
• Give the appropriate title of your chart and click the Apply button.

• You can change the scale of Y-Axis values as follows:

• Click the Save Changes button to persist the changes.

• Your final Box and Whisker Column Chart will appear below.

Insights

• Stocks show the greatest average Sharpe ratio, with values between 0.7 and 1.2.
• Real Estate also demonstrates solid risk-adjusted returns ranging from 0.6 to 1.
• Cryptocurrency falls in the middle, with values ranging from 0.7 to 0.88, while Bonds and Commodities have lower Sharpe ratios.

FAQs

What is an appropriate Sharpe ratio?

An appropriate Sharpe ratio typically ranges from 1 to 3. A ratio above 1 is considered acceptable, above 2 is good, and above 3 is excellent. These benchmarks indicate favorable risk-adjusted returns.

What is a good Sharpe ratio for day trading?

For day trading, a good Sharpe ratio is generally above 2. This indicates strong risk-adjusted returns. Ratios above 3 are excellent and suggest very favorable performance. High Sharpe ratios help ensure the trading strategy effectively balances risk and return.

What is considered a low Sharpe ratio?

A low Sharpe ratio is typically below 1. This indicates that the investment’s returns do not adequately compensate for the risk taken. Ratios below 0.5 are considered poor, suggesting unfavorable risk-adjusted performance.

Wrap Up

Knowing what is a good Sharpe ratio is vital when assessing investment success. The Sharpe ratio assesses the relationship between returns and risk, looking at how effectively an investment rewards risk. A higher Sharpe ratio signifies superior performance when considering risk.

A Sharpe ratio above 1 is generally acceptable. It suggests the investment provides reasonable returns for the risk incurred. Investors often look for ratios above 1 when assessing potential investments – it indicates that returns outweigh the risk.

Ratios above 2 are seen as good. These suggest that the investment offers strong returns relative to its risk. A Sharpe ratio in this range signals a solid investment opportunity for many investors. This means that the strategy effectively manages risk while achieving desirable returns.

Ratios above 3 are considered excellent. Such high ratios indicate exceptional risk-adjusted performance. Investments with Sharpe ratios above 3 are rare and typically reflect highly efficient strategies. These investments provide significant returns for relatively low risk, making them highly attractive.

In conclusion, a good Sharpe ratio varies by context, but generally:

• Ratios above 1 are acceptable
• The above 2 are good
• The above 3 are excellent.

Understanding these benchmarks helps to evaluate and compare investments effectively.