Sharpe Ratio

Investment performance is best described by the Sharpe ratio. Sharpe ratio describes the stability of an investment returns.

The aim of an investment is to generate the maximum average return with the minimum volatility.

Investment Guide

Sharpe Ratio Example:

An investor has to choose between two investments with the equity curves displayed above. Although Investment 2 has a higher ending value than Investment 1, it has much higher volatility and drawdown than Investment 1. As a result, Investment’s 1 Sharpe Ratio is 3 times higher than Investment’s 2 Sharpe Ratio and hence Investment 1 is preferred.

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Sharpe Ratio Formula

Sharpe Ratio Formula

The Sharpe ratio is calculated by using the average annualized returns of a strategy adjusted by the risk free interest rate in the number and the annualized volatility in the denominator.
To check an investment’s performance correctly, the Sharpe Ratio must be calculated based on the investment’s performance during long historical periods of at least 10 to 20 years including financial crisis like 2008.

Any investment that has a Sharpe ratio of less than 1 is not acceptable. Investments with Sharpe Ratio between 1.5 and 2.0 are excellent investments. Investments achieving profitability every month, the annualized Sharpe ratio is greater than 2. Invesments profitable almost every day, the Sharpe ratio is greater than 3.
Sharpe Ratio Calculation Steps:

  1. Download Investment’s Monthly Closing Prices
  2. Calculate Investment’s Monthly Returns using the formula (Pclosing – Popen)/Popen
  3. Calculate the Standard Deviation of monthly returns
  4. Calculate the Annualized Returns by multiplying returns by 12 (for monthly returns)
  5. Calculate the Annualized Standard DEviation by multiplying monthly standard deviation by the square root of 12
  6. Get 1-year Treasury note yield using this link
  7. Use Sharpe Ratio Formula to calculate the Sharpe Ratio

Notes:

The risk-free rate must be subtracted only for strategies that have financing costs. Intraday Strategies (no overnight positions) and Dollar Neutral Investmentss (Dollar Neutral Portfolios are self-financing that is cash from selling short pays for purchase of long positions) don’t require subtracting the risk-free rate. Long only strategies require subtraction.

Annualized Sharpe Ratio
To calculate the annualized Sharpe ratio you need to annualize the returns and standard deviation of an investment. To generate annualized returns you have to multiply daily monthly returns by 252 and to annualized standard deviation you have to multiply standard deviation by square root of 252.