William F. Sharpe, an Economic Sciences Nobel Laureate, developed the Sharpe Ratio to help investors measure the return of an investment compared to its risk. An investment with a higher Sharpe ratio is typically considered more attractive as it offers a higher return for a given amount of risk.
The Sharpe Ratio can be used to evaluate the past performance of a portfolio or it can be used with expected returns and the expected risk-free interest rate to estimate the portfolio's future Sharpe Ratio.
The Sharpe Ratio is used to express how much extra return is gained from holding riskier assets. A higher Sharpe ratio means that the investment holds a better risk/return ratio.
The Sharpe Ratio is the foundation of Modern Portfolio Theory which says that adding assets to your portfolio which have low-correlations can decrease the risk of your portfolio. Correlation is how similar the returns of two investments are. Highly correlated assets tend to move in the same direction. Adding a diverse set of investments to your portfolio should result in an increase in your portfolio’s Sharpe Ratio by lowering the overall volatility.
The Sharpe Ratio is the Average Return (%) of a portfolio less the Risk-Free Rate of Return per Unit of Volatility.
(Return of Portfolio - Risk Free Rate of Return)
Unit of Volatility
The Average Return of an investment (or portfolio) is simply the average rate of return experienced. The Risk Free Rate of Return comes to us from the rate of return for a Zero-Coupon Government Bond (STRIPS)*. The government bond used for calculations should match the accompanying investments maturity, i.e. if you are calculating cash flows for the next 10 years, you will want to use the return of the 10-year STRIPS. The Unit of Volatility is calculated by taking the standard deviation of the investment’s excess returns.*STRIPS are preferred over regular government bonds because STRIPS do not make interim interest payments.