Calculate the Sharpe Ratio to Gauge Risk

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

Key:

• Rp: Investment return (actual or forecast)
• Rf: Risk-free return (investor chooses a specific U.S. Treasury bill or note for this data—more below)
• Standard deviation: A measure of risk based on the investment’s volatility; A lower standard deviation implies less risk and consequently a higher Sharpe ratio, while a higher standard deviation implies more risk and a lower Sharpe ratio, all else being equal

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."

Sharpe ratio results are either positive or negative and follow these ranges.

• Positive Sharpe ratio ranges:
  • 0.0 and 0.99 is considered low risk/low reward
  • 1.00 and 1.99 is considered good
  • 2.0 and 2.99 is very good
  • 3.0 and 3.99 is outstanding

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. 

• Negative Sharpe ratios below 0 indicate the investment is "suboptimal" and should be avoided because it has very high risk and very low reward.

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:

• The Sharpe ratio alone does not reveal whether leverage was used to produce the returns. Fund managers can use leverage to boost returns and potentially gain a higher Sharpe ratio. This is one piece of information investors will have to dig out themselves by looking at the investment fund's prospectus or fact sheet.
• The Sharpe ratio fails to account for the length of the return’s track record. For example, an investment fund with a relatively short track record, say six months, could annualize its returns for the purposes of calculating the Sharpe ratio over the course of a year. That would mean a significant portion of the returns are hypothetical and do not reflect a true return. Again, caveat emptor.
• The Sharpe ratio treats all market volatility the same. Upside volatility is what investors seek, but the subsequent higher volatility measure in the denominator would result in a lower Sharpe ratio. That could potentially send an investor elsewhere, leading them to miss a better risk-adjusted opportunity.

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 interested in learning about other key portfolio return measures and what they mean for your portfolio, check out the Information ratio and Sortino ratio.