Sharpe ratio. Using the Sharpe ratio is one way to compare the relationship of risk and reward in following different investment strategies, such as emphasizing growth or value investments, or in holding different combinations of investments.
To figure the ratio, the risk-free return is subtracted from the average return of an investment portfolio over a period of time, and the result is divided by the standard deviation of the return.
A strategy with a higher ratio is less risky than one with a lower ratio.
This type of analysis, which is done using sophisticated computer programs, is named for William P. Sharpe, who won the Nobel Prize in economics in 1990.
What Does Sharpe Ratio Mean?
A ratio developed by Nobel laureate William F. Sharpe that is used to measure risk-adjusted performance. The Sharpe ratio is calculated by subtracting the risk-free rate, such as that of the 10-year U.S. Treasury bond, from the rate of return of a portfolio and then dividing the result by the standard deviation of the portfolio returns.
Investopedia explains Sharpe Ratio
The Sharpe ratio indicates whether a portfolio's returns are due to smart investment decisions or are a result of excess risk. This measurement is very useful because although one portfolio or fund can reap higher returns than its peers, it is a good investment only if those higher returns are not a result of taking on too much additional risk. The greater a portfolio's Sharpe ratio is, the better its risk-adjusted performance has been. A variation of the Sharpe ratio is the Sortino ratio, which removes the effects of upward price movements on standard deviation to measure only return against downward price volatility.
Related Terms:
• Portfolio
• Risk
• Risk-Free Rate of Return
• Standard Deviation
• Total Return
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