What Is The Sharpe Ratio? Balancing Risk And Reward In Investing

Updated: May 20, 2021

When investing, we tend to focus a lot on maximizing our returns - but what about risk? Many investors saw great returns from meme stocks like GameStop in January, but is seeking astronomical returns with risky stocks the best way to build wealth over the long term?

There are good days and bad days in the market, so you want to manage your risk.

The Sharpe Ratio comes into play to help us make smarter investment decisions by balancing risk and reward. The Sharpe Ratio can give insight into whether a portfolio was just lucky or good (or unlucky or bad).

Risk Reward Quote Seth Klarman

Risk-Return Example

Think about this. If I offered you the choice between the following investments, which would you take?

  • Investment A: 100% chance (guarantee) of a 10% return

  • Investment B: 50% chance of 5% return and 50% chance of a 15% return

Investment A is a much safer bet with a better return after adjusting for risk.

Sharpe Ratio Definition

The Sharpe Ratio, made famous by William Sharpe in 1966, is a measure of the risk-adjusted returns of an investment or portfolio. It weighs the returns against the risk of an investment for a more complete view of performance.

How To Calculate Sharpe Ratio

The Sharpe Ratio of an investment is measured by subtracting the risk-free rate from the average return of the investment, then dividing that by the standard deviation of the excess return of the investment.

The formula measures the return over the risk of an investment while subtracting out the rate of return you could get with zero risk (risk-free rate).

Sharpe Ratio Formula

Example Sharpe Ratio Calculation

Let’s compare two example portfolios.

Portfolio A

  • Rate of return = 11%

  • Risk-free rate = 3%

  • Standard deviation of excess return = 6%

Portfolio B

  • Rate of return = 8%

  • Risk-free rate = 3%

  • Standard deviation of excess return = 2%

Which portfolio would you choose? Which one has a higher Sharpe Ratio?

Portfolio A has a Sharpe Ratio of 1.33 and portfolio B has a Sharpe Ratio of 2.5.

Portfolio A has a higher overall return (11% vs 8%) but takes on a lot more risk in doing so. Which one to choose is up to you and based on your appetite for risk.

How To Interpret The Sharpe Ratio

Now that we know how to calculate the Sharpe Ratio, what does the number mean?

Well, for starters, you can use the Sharpe Ratio to compare different investments. The higher the Sharpe Ratio, the better the returns when adjusting for risk. Different investors at different stages of life will have different thresholds for risk and reward, so it’s up to you to determine what makes sense for you at this time.

A Sharpe Ratio less than 1 is usually not a good sign and means you are taking on more risk than the expected reward. As you move beyond 1 and look for greater returns, think about how much additional risk you are willing to take on for the potential reward.

Speculative Investing

Lots of new investors look for high returns by picking speculative stocks with little research behind their decision. Sometimes this works out by sheer luck, but it could eventually lead to large losses. Investing is risky, but risk isn’t necessarily a bad thing. The important thing is to balance risk with reward.

All Of Us Financial Sharpeshooter Challenge

Part of the mission at All Of Us is to educate investors to make informed decisions about their investments. That’s why we came up with the Sharpeshooter Challenge which rewards the person with a 10% bonus who has the highest return with the lowest risk, the highest Sharpe Ratio.

This monthly challenge is meant to educate our investors about smart investing principles and reward them for doing it well. You can also track your Sharpe Ratio against other members on the platform with our leaderboards feature. Join the mission today and start trading with All Of Us.

Note: The investing information provided on this page is for educational purposes only.

95 views0 comments