What is so “Sharpe” about The Sharpe Investor?

By Megan Kowalski on April 13, 2021

Welcome to the first of many installments of The Sharpe Investor. My hope with this blog is that it will foster confidence in making well-informed financial decisions as well as deepen your understanding of the investment and economic landscape. I thought it would be prudent to start with the Sharpe Ratio as it is referenced in the title of this blog. Let’s get to learning!

What is the Sharpe Ratio?

Definition: The Sharpe Ratio is a calculation developed by William F. Sharpe, an American economist, in 1966 to assist investors in comparing the return of an investment with its associated risk.

To calculate the Sharpe Ratio, take the return of the portfolio minus the risk-free rate and divide that over the standard deviation. Don’t let me lose you just yet! The standard deviation is a measure to assess the risk or how certain the return rate is over time.

If a company’s stock price regularly fluctuates from $2-$100, it will be more volatile and therefore “riskier” than a company that fluctuates between $45-50 over that same period.

A popular indicator of the risk-free rate is the U.S. Treasury since it carries little to no risk of losing your initial investment. See equation below:

R_p = Return of Portfolio

R_f = Risk-Free Rate

σ_p = Standard Deviation of the Portfolio’s Excess Return

Okay, now you lost me… What is the Sharpe Ratio?

I know this looks like a foreign language but it’s just a fancy equation for measuring an investment’s risk/reward. The equation addresses the question of whether you are being compensated properly for the risk the investment bears.

This is highlighted in a quick example below:

Prior to learning about the Sharpe Ratio, most investors simply compare the returns of each company. On the surface, Company B looks much more attractive due to the higher return. Now, let’s calculate the Sharpe Ratio for each:

As you can see from the example above, the Sharpe Ratio for Company A is significantly higher and therefore offers a better risk/reward investment opportunity when compared to Company B.

So what is it good for? Absolutely nothing. (Just kidding, sorry couldn’t resist)

The Sharpe Ratio is a very powerful tool and can be helpful in certain situations. Let’s say you have two companies that look similar on paper. They are in the same industry; have similar returns, and you are torn as to which one you should invest in. The Sharpe Ratio can help answer that question for you by helping make an apples-to-apples comparison to see which company has the highest overall risk/reward.

Alright, now what is the catch?

Well like most things in life, nothing is perfect. That too holds true with the Sharpe Ratio.

1. The standard deviation used to measure the risk is assuming the variation of the returns are normally distributed for each investment and well, that is just not true. Many times, returns are skewed one way or another.
2. It is often disregarded because it ignores the correlation of the risk to the overall market. This is how the Treynor Ratio came to be which compares the company’s risk premium over the risk-free rate to their beta (a measure of how risky an investment is compared to the market).
3. Beware! The Sharpe Ratio is based on a specific period of time. It is imperative to compare the same time period for each investment.

Does this mean I need to start calculating everything?

No, the Sharpe Ratio can be a handy tool for certain situations, but it is not realistic nor beneficial to use on a regular basis. Instead, the main lesson it teaches is making sure to assess the risk/reward of an investment before being blinded by flashy returns. Not all returns are made equal!

I hope that today’s blog has helped sharpe-n your knowledge of the investment landscape. If you have any topic suggestions or have further questions, please reach out to mkowalski@hightoweradvisors.com.

Happy learning!

-Meg