What is the Sharpe ratio?
The Sharpe ratio helps investors calculate an investment's risk-adjusted rate of return. The higher, the better.
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Created by William F. Sharpe, a Nobel Prize–winning economist, the Sharpe ratio measures an investment’s return per unit of risk. It’s a popular metric used to evaluate stocks, exchange-traded funds (ETFs), mutual funds and other investments.
The ratio can be calculated using historical data or forecast returns. When using forecast data, remember that forecasts are not reliable predictors of future performance.
How to calculate the Sharpe ratio
To calculate the Sharpe ratio of an investment, choose a “risk-free” security that matches your investment horizon as a control. For example, for a five-year holding period, you could use a five-year Government of Canada bond or U.S. Treasury bill. Subtract the rate on this bond or T-bill from your investment’s actual or forecast return. Then divide by the investment’s standard deviation, a measure of risk based on volatility.
Sharpe ratio = (Investment return – Risk-free rate) ÷ Standard deviation
Example: “The Sharpe ratio of Ned’s portfolio was negative, reflecting high risk with low reward. A number between 1.0 and 2.0 is considered good, 2.0 to 3.0 very good and 3.0 or higher, excellent.”
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