What is Portfolio Sharpe Ratio?
The Sharpe ratio is a widely used measure to evaluate the risk-adjusted return of a portfolio. It compares the excess return of the portfolio (above the risk-free rate) to the portfolio's total risk, represented by its standard deviation. The higher the Sharpe ratio, the better the portfolio's risk-adjusted performance, meaning the investor is receiving more return per unit of risk.
Sharpe Ratio Calculation: The formula for the Sharpe ratio is:
Sharpe Ratio = (Portfolio Return - Risk-free Rate) / Portfolio Standard Deviation Where:
Sharpe Ratio = (10% - 2%) / 15% = 0.53 This means the portfolio is earning 0.53 units of return for every unit of risk, which indicates moderate risk-adjusted performance.
Sharpe Ratio Calculation: The formula for the Sharpe ratio is:
Sharpe Ratio = (Portfolio Return - Risk-free Rate) / Portfolio Standard Deviation Where:
- Portfolio Return: The average return generated by the portfolio
- Risk-free Rate: The return of a risk-free asset, such as government bonds
- Portfolio Standard Deviation: A measure of the portfolio's overall volatility
Understanding the Sharpe Ratio
The Sharpe ratio helps assess the efficiency of a portfolio in generating returns for a given level of risk:- Higher Sharpe Ratio: Indicates that the portfolio is generating more return per unit of risk. A higher ratio is desirable because it means the portfolio is efficiently compensating investors for the risk they are taking.
- Lower Sharpe Ratio: Suggests that the portfolio is generating less return for the level of risk taken, which may indicate poor risk management or inefficient asset allocation.
- Negative Sharpe Ratio: Means that the portfolio is underperforming the risk-free rate, indicating that the investor would have been better off investing in a risk-free asset.
Example Calculation
Suppose a portfolio has an average return of 10%, a risk-free rate of 2%, and a standard deviation of 15%. Using the formula:Sharpe Ratio = (10% - 2%) / 15% = 0.53 This means the portfolio is earning 0.53 units of return for every unit of risk, which indicates moderate risk-adjusted performance.