What Is the Sharpe Ratio? Formula and Example

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1) The Sharpe Ratio is the excess return of an investment divided by the standard deviation of returns, which is a measure of risk. Excess returns are returns in excess of a risk-free investment. T-Bills are commonly used to estimate a risk-free return.

2) The Sharpe Ratio helps to normalize the risk/reward proposition of an investment. To only look at returns ignores important risks. For example, the NASDAQ index has had higher returns than the S&P 500, but the volatility can be much higher as well. This excess volatility may render an investment to be inappropriate for some investors.

3) The S&P 500 itself generates a Sharpe Ratio around 0.50 when measured with monthly returns. Back when I was working in algorithmic trading, a strategy below 1.00 wasn't worth discussing with funders. 2.00 was respectable. It's important to note that typical investors may not have access to strategies generating these ratios. These strategies usually employed short sales, high frequency trading, and leverage which are not suitable for many investors.

Bonus) Part of the rationale of the Sharpe Ratio was to apply leverage to profitable strategies. A ratio above 1.00 indicates that an investment would earn more return for every unit of additional risk. This is critically important if you're increasing risk by using leverage. However, the Sharpe Ratio doesn't fully capture the potential for catastrophic losses.