Glossary · UK
What is Sharpe Ratio?
A measure of investment return earned per unit of risk taken, calculated by comparing return above the risk-free rate against volatility.
Full Definition
The Sharpe ratio is a widely used measure of risk-adjusted investment performance, calculated by taking a portfolio's return above a risk-free benchmark (such as short-dated UK government gilts) and dividing it by the volatility (standard deviation) of that portfolio's returns over the same period, giving a single figure for how much extra return was earned for each unit of risk taken on. A higher Sharpe ratio indicates a more efficient risk-return trade-off -- either more return for the same risk, or the same return for less risk -- which makes it useful for comparing two funds or portfolios with different levels of volatility rather than looking at raw returns alone, since a fund that achieved a higher return simply by taking on much greater risk is not necessarily the better investment once risk is accounted for. The ratio has well-known limitations: it uses standard deviation as its measure of risk, which treats upside and downside volatility equally even though most investors only really mind the downside, and it is calculated over a specific historical period, so a favourable Sharpe ratio measured over one period (particularly a strongly rising market) is not a guarantee of similarly favourable risk-adjusted returns in future. Despite these limitations, the Sharpe ratio remains one of the standard figures quoted in fund factsheets and used by financial advisers and platforms to help compare funds with different risk profiles on a more like-for-like basis than comparing headline returns in isolation.
How Sharpe Ratio is calculated
Sharpe ratio = (Portfolio return - Risk-free rate) / Standard deviation of portfolio return- Portfolio return
- The average return achieved by the investment or portfolio over the period measured.
- Risk-free rate
- The return available on a virtually risk-free asset, e.g. short-dated UK government gilts or NS&I products.
- Standard deviation
- A measure of how much the portfolio's returns varied (its volatility) over the same period.
Worked example: A fund returning 8% a year with a 4% risk-free rate and 10% standard deviation has a Sharpe ratio of (8-4)/10 = 0.4. A higher figure means more return was earned per unit of risk taken.