The Sharpe Ratio

What is the Sharpe Retio? There are two nuggets of knowledge that will help you answer this question correctly.

In this video, I’m going to work through a question that deals with the Sharpe ratio. Specifically, it asks about the Sharpe ratio for the entire stock market itself. Candidly, when I first came across this question during my studies, I hadn’t really thought about it before, and I wasn’t overly confident in my answer. That’s okay. Always remember, when you’re preparing for an exam, even if you get a question wrong, that’s not necessarily a bad thing. Think of it as an opportunity to learn something new.

There are two nuggets of knowledge that will help you answer this question correctly. Nugget number one, the Sharpe ratio measures the return per unit of risk of an individual security, such as a stock, or of an entire portfolio, such as a mutual fund or an investor’s retirement account. Now depending on the course you are taking, the actual formula may be beyond the scope of what you need to know. But let’s still take a look at it because it will help you better understand the concept. Let’s consider a portfolio as we discuss the Sharpe ratio. On the top of the formula, you find the return of the portfolio less the risk-free rate of return. So basically, how much extra did the portfolio earn over and above what it could have earned if it were invested in a risk-free investment, such as a 90-day treasury bill? On the bottom of the formula, we find standard deviation, which is considered a measure of risk. For example, the more a securities return deviates from year to year, the more volatile it is and the more risk it represents. The higher the standard deviation, the higher the risk. So to sum up the Sharpe ratio, it measures the return per unit of risk accepted.

Nugget number two, all else being equal, the higher the Sharpe ratio, the better. Think about it this way. All of the following statements are true. If you invested in a very safe T-bill, you would still say the higher the return, the better. And if you invested in a medium-risk investment, you would still say the higher the return, the better. And if you invested in a very high risk investment, you would again say the higher the return, the better. Makes sense, right? It doesn’t matter what type of investor you are or what you are invested in. The higher the Sharpe ratio, which is the return per unit of risk accepted, the better.

Now here is a great memory aid. Being “Sharpe”, or smart, is always a good thing. With all this in mind, let’s circle back to the question I referenced at the top of this video. What is true of the Sharpe ratio for the entire market? Tricky, right? Well, here’s a great way to rationalize it. The Sharpe ratio for a portfolio could be any number. If you think of the market as a gigantic portfolio, then it makes sense that the Sharpe ratio for it could be any number too. Let’s pick that answer and see, and fortunately, we’re correct.

Here’s the great thing though. Even if you answered it wrong, our detailed answer key would shed some light on the concept and you would have learned from that mistake. That is why you practice.