How to calculate risk-adjusted returns using the Sharpe Ratio

The Essential Sharpe Ratio for Investment Decisions

For investors, the question of “how much risk to take to achieve a certain return” is always present. The Sharpe Ratio, proposed by William F. Sharpe in 1966, is a powerful tool to answer this question. In simple terms, it is an indicator used to determine which investments generate higher returns at the same risk level.

Calculation Formula and Meaning of the Sharpe Ratio

The calculation of the Sharpe Ratio is as follows:

Sharpe Ratio = (Rp - Rf) ÷ σp

• Rp: Expected portfolio return
• Rf: Risk-free rate
• σp: Standard deviation of the portfolio

In other words, it measures the excess return over a safe asset, divided by volatility (variability). It indicates “how many units of return can be obtained per unit of risk.”

Application in Portfolio Management

Decision criteria when comparing multiple investments

Suppose there are two investment options, A and B. A has an annual return of 20% with a volatility of 25%, while B has an annual return of 15% with a volatility of 10%. At first glance, A appears to have a higher return. However, calculating the Sharpe Ratio reveals the return efficiency per unit of risk. Fund managers and individual investors use this indicator to optimize portfolios and determine more efficient asset allocations.

Assessing the balance between risk and return

A higher Sharpe Ratio indicates better risk-adjusted performance. This allows investors to make decisions based on quantitative evidence rather than emotions or intuition.

Understanding the Limitations of the Sharpe Ratio

This tool is not perfect. There are some important considerations:

• Difficulty interpreting negative values: When the Sharpe Ratio is negative, comparisons may lose meaning.
• Assumption of normal distribution: The formula assumes returns are normally distributed, which may not hold true in real markets.
• Dependence on historical data: Since it relies on past volatility to predict future performance, it may not respond well to sudden market changes.

The Sharpe Ratio is merely one criterion among many. Combining it with other indicators and qualitative analysis leads to more robust investment decisions.