"Every investment carries risk." It's a common saying, but an important reminder. Returns matter, but so does how much risk you take to achieve them.

There are different ways to measure investment risk, and the Sharpe Ratio is one of them. It helps investors compare portfolios, assets, and funds based on risk-adjusted returns.

Developed by William Sharpe in 1966, this metric isn’t perfect, but it’s widely used. A higher ratio implies better risk-adjusted performance, but context matters. Here’s how it works and when it’s useful.

What is the Sharpe Ratio?

The Sharpe Ratio seeks to measure how much risk an investment takes to achieve its returns. It does this by calculating how much extra return an investment generates above the risk-free return, adjusted for its volatility. A higher ratio implies better risk-adjusted returns, but it’s not the only factor to consider.

Its purpose in finance and investing

This metric can help investors compare different assets based on relative risk. It’s often used for exchange-traded funds (ETFs) , shares , and managed funds . The goal is to assess whether an investment’s returns justify its risk.

Why it matters for comparing investments

Returns alone don’t tell the full story. Two investments may deliver the same returns, but the one with less risk has a higher Sharpe Ratio. This can make it useful for portfolio construction and risk management. However, a negative Sharpe ratio can indicate an investment has underperformed relative to a risk-free return.

Who created it?

As mentioned, the economist William F. Sharpe developed the ratio in 1966 as part of asset pricing research. It became widely used because it offers a simple way to compare investment performance while accounting for risk. Many fund managers rely on it, but it has limitations, which we’ll cover later.

How is the Sharpe ratio calculated?

The Sharpe ratio is calculated using this formula:

Sharpe Ratio = (Investment Return - Risk-Free Return) ÷ Standard Deviation of Returns

Breaking down the formula

Each part of the formula plays a key role:

• Investment return – The average annual return an investment has earned over a period.
• Risk-free return – The return from a low-risk investment, often government bonds , which helps compare whether taking extra risk was worthwhile.
• Standard deviation of returns – A measure of how much an investment’s returns move up and down. The higher the number, the more unpredictable the returns.

Example calculation

Let’s say an ETF had an average annual return of 10% , while the risk-free return was 3% . If the ETF’s returns fluctuated with a standard deviation of 12% , the calculation would be:

Sharpe Ratio = (10 - 3) ÷ 12
Sharpe Ratio = 7 ÷ 12
Sharpe Ratio = 0.58

A Sharpe Ratio of 0.58 means this ETF provided some extra return for the risk taken. But as we’ve said, the ratio alone doesn’t tell the full story – it’s most useful when comparing similar investments.

What does the Sharpe Ratio tell investors?

As we’ve said, the Sharpe Ratio helps investors understand whether an investment’s returns have been worth the risk taken to achieve them. It adjusts for volatility, making it easier to compare investments fairly.

How it measures risk-adjusted returns

Two investments may offer the same return, but if one is much more volatile, it carries higher risk. The Sharpe ratio accounts for this by comparing an investment’s extra return (above the risk-free rate) to how much its returns fluctuate.

Interpreting high vs. low Sharpe ratios

• High Sharpe ratio – Suggests an investment has historically provided better risk-adjusted returns, meaning investors took on less risk for each unit of return.
• Low or negative Sharpe ratio – May indicate the investment carried too much risk for the returns achieved or even underperformed a risk-free investment.

A high Sharpe Ratio doesn’t guarantee future performance, as it relies on historical data. This is just one of its limitations, which we’ll talk about soon. For a clearer picture, investors often look at the Sharpe Ratio alongside other risk measures before making decisions.

How can investors apply the Sharpe Ratio?

The Sharpe Ratio can help investors compare funds, assess risk-adjusted performance, and understand whether an investment’s returns justify its volatility. However, it works best when reviewed with other factors.

Evaluating ETFs and managed funds

As highlighted earlier, the Sharpe Ratio is often used to compare ETFs and managed funds. A higher ratio suggests a fund has delivered more returns per unit of risk, but that doesn’t mean it will continue to do so. Investors can use it to see how funds stack up over time, but comparisons are most useful when looking at similar investment types.

Assessing risk-adjusted performance within a portfolio

The Sharpe Ratio can also measure how much risk a portfolio is taking to achieve its returns. A portfolio with a higher ratio has historically delivered better risk-adjusted performance.

But as mentioned, risk isn’t the only factor to consider. A balanced portfolio may include investments with different risk levels for diversification, not just those with the highest Sharpe ratio.

How the Sharpe Ratio is used in real-world investing

The Sharpe Ratio isn’t just a theoretical concept – it’s widely used by fund managers, analysts, and individual investors to compare investment options.

How fund managers and analysts use it

• Comparing investment performance – Fund managers track the Sharpe Ratio to see if a portfolio’s returns justify its risk.
• Optimising portfolios – Some managers adjust asset allocation based on the ratio, aiming for better risk-adjusted performance.
• Benchmarking against other funds – Analysts use it to compare managed funds or ETFs in the same category.

A practical example: comparing two ETFs

Imagine an investor is choosing between two ETFs . Here’s how the two ETF returns compare:

1. ETF A has an average annual return of 8% .
2. ETF B has an average annual return of 9% .

At first glance, ETF B looks better because it has a higher return than ETF A. Many investors might assume that a fund with higher returns is always the better option. However, they also need to consider the risk taken to achieve those returns. Here’s how the risk levels compare between the ETFs in this example:

1. ETF A has a standard deviation of 10% .
2. ETF B has a standard deviation of 15% .

At this stage, the investor sees that ETF B has more return but also more volatility. This means its returns fluctuate more, which could make it a riskier option.

Now, let’s calculate the Sharpe ratio, assuming a risk-free return of 3%:

• ETF A: (8 - 3) ÷ 10 = 0.50
• ETF B: (9 - 3) ÷ 15 = 0.40

Even though ETF B has a higher return, ETF A has a higher Sharpe Ratio, suggesting it delivers more return per unit of risk. So for every unit of risk, ETF A provides a potentially higher reward. If an investor values smoother, more stable returns, they might prefer ETF A. But if they’re comfortable with more risk in exchange for potentially higher returns, ETF B could still be appealing.

Again, the Sharpe Ratio doesn’t guarantee future performance or account for all investment risks. The example above is also for educational purposes only and does not consider factors like fees, taxes, or market conditions , which can impact actual investment returns. Think about your risk tolerance , goals, and investment strategy before making any decisions.

Limitations – why a higher ratio isn’t always better

The Sharpe Ratio is widely used, but it has limitations . Here are some:

• It doesn’t show whether an investment fits an investor’s goals . It also doesn’t account for time horizon, diversification, or personal risk profile. For example, a long-term investor might choose a growth-focused ETF with a lower Sharpe Ratio if they believe it offers strong future returns.
• As it relies on historical data , the Sharpe Ratio may not reflect future market conditions.
• It also assumes returns follow a normal pattern , which isn’t always the case. For example, many investments , like stocks , experience tailed return streams , meaning returns aren’t always evenly spread.
• It penalises upside volatility and treats all fluctuations as risk, even when returns are consistently positive . In volatile markets, other metrics may provide a clearer view of risk-adjusted performance.

Alternative risk-adjusted return metrics

The Sharpe Ratio is just one way to compare investments. Here are other metrics that provide different ways to assess risk-adjusted returns:

• Sortino Ratio – Similar to the Sharpe ratio, but only considers downside risk. It may be more useful for long-term investors who don’t mind short-term price swings for long-term gains.
• Treynor Ratio – Focuses on market risk instead of total volatility, making it useful for comparing portfolios or funds with different risk levels.

Each metric has strengths and weaknesses, and investors can use multiple tools to assess an investment’s potential.

Final thoughts: making sense of risk and returns

The Sharpe Ratio helps investors compare investments by adjusting for risk, but it’s not the only measure that matters. It works best when comparing similar assets and considering other factors like diversification, time horizon, and investment objectives.

Though a higher Sharpe Ratio suggests better risk-adjusted returns, context is key. It doesn’t guarantee future performance or account for all investment risks. Ultimately, no single ratio can make investment decisions for you. Understanding risk-adjusted returns can help, but choosing investments should align with your strategy, financial goals, and risk tolerance.