A Sharpe Ratio calculates the extra return of an investment in return for the extra risk taken on.
It is used to compare different investments to see which one did better given the different risk of each.
It is measured as taking the difference between a risk-free and a risky asset, and then dividing the difference by the Standard Deviation (which is a value of risk) of the stock / portfolio.
It was named after William Forsyth Sharpe (who now teaches Finance to graduate students at Stanford University) in 1966 after he developed a strategy to maximize the reward to risk relationship.
William Sharpe is also one of the original contributors to the globally accepted Capital Asset Pricing Model (CAPM) for stock returns.
What does it mean?
The Sharpe Ratio demonstrates the excess returns generated in return for the excess risk taken on by the investor.
It is a measure which can be used to compare two or more investments to show which one earned the most excess return given the least amount of extra risk.
Two Stocks or Portfolios that generate the same return over a certain period might not be the same in terms of the risk taken to invest in each of them.
One of them might have been more volatile during that period, meaning that our risk for that stock / portfolio was greater.
Thus, the other stock/ portfolio would have been a wiser investment in terms of lower volatility (risk) for the same return.
Generally, the greater the Sharpe Ratio, the better the risk adjusted return on that Stock / Portfolio.
A Sharpe Ratio ≤ 0 would means that it would have been better to invest in the Risk-Free Asset than the Stock / Portfolio being analyzed.
Example
Risk –Free Rate (Savings Account at ING Direct) = 3%
Stock A = Apple (AAPL)
3-Month Return = 22%
Standard Deviation = 1%
Sharpe Ratio for AAPL = (0.22 – 0.03)/(0.01) = 19
Stock B = Google (GOOG)
3-Month Return = 24%
Standard Deviation = 2%
Sharpe Ratio for GOOG = (0.24 – 0.03)/(0.02) = 10.5
Results:
(i) Since both stocks had Sharpe Ratios greater than Zero, It was better to invest in one of them than to save the money at ING at 2%
(ii) Even though GOOG had a slightly higher return that AAPL (24% > 22%), it would have been wiser to invest in AAPL as AAPL had a higher excess return per unit of risk than GOOG (19 > 10.5)
Limitations of Sharpe Ratio
The limitation of the Sharpe Ratio is that it just tells you that one investment was better than the other comparing risk, but does not tell you HOW MUCH better that investment was.
In other words, there are no units to measure the added benefit from choosing one investment over another.
Conclusion
The Sharpe Ratio is a useful tool to evaluate the actual risk-adjusted performance of two or more stocks.
When put next to each other, it shows us which stock gives a higher return for the same amount of risk.