What Is A Good Sharpe Ratio? [2022 Guide]
If you have ever considered investing, or gone to the bank for a loan, you will probably be familiar with the term ‘Sharpe ratio’ – which, in broad terms, is a way for investors to compare the risk of a potential investment compared to the possible returns — it’s a bit more complicated than that as we’ll explain below.
Before we get into what a sharpe ratio is and why it’s useful we’d like to first say while calculating your portfolios sharpe ratio can be useful and be part of a good portfolio strategy it is not at all necessary to include it as part of your strategy.
So don’t stress too much about your sharpe ratio or if it’s good or not according to what we outline below — there’s plenty of cases where a portfolio with a bad historical sharpe ratio has done fantastic, and there’s many cases where someones specific goals and assumptions about the market may cause them to have a ‘non-ideal’ sharpe ratio.
If you’re okay with high levels of volatility in your portfolio and do some active management, you may have a less ideal sharpe ratio than another investor who has a lower return than you do over the long-term — basically sharpe ratios are a good tool, but they’re not the be-all end-all investing metric.
Table of Contents
What Is A Sharpe Ratio & Why Is It Useful?
The Sharpe Ratio is used to determine whether an investor should invest in stocks or bonds. For example, if you want to know whether investing in stocks is better than investing in bonds, the Sharpe Ratio can be used.
This ratio compares the stock market’s returns to the interest rates paid on treasury bills over a specific period of time. Sharpe Ratios are named after William F. Sharpe, who developed this concept while working at Goldman Sachs. He was one of the first people to use statistics to compare different investments – and this specific stat is still used to guide investors on whether their potential investments are worth it – by comparing potential yield/profit to potential risk.
The Sharpe Ratio measures the return on an investment against the rate of interest on government securities, and then factors in the volatility of the investment (lower volatility is better according to the ratio). It does not measure the performance of any individual security. Instead, it measures the average return on an investment portfolio as a whole, minus the ‘risk-free’ rate of fiat money (government bond rate), over the volatility of the investment portfolio as a whole.
Why Should You Care About Your Sharpe Ratio?
Your Sharpe ratio is important because it helps you understand whether your investment strategy is working or not and if it carries an outsized amount of risk relative to the return you’re getting on the investment. By calculating your Sharpe ratio, you can determine whether you are making more money than you expected or less money than you expected relative to the level of risk the investments in your portfolio have (in your view).
You can also use the ratio to compare your portfolio vs your peers or index’s to see if your portfolio has an overall better performance relative to it’s risk than index’s such as the S&P 500 when factoring in volatility.
Why Sharpe Ratios Are Important?
In investment world, the Sharpe ratio is a really important stat because:
- The Sharpe Ratio allows investors to compare the risks associated with different types of investments.
- It tells us whether we should invest in stocks or treasuries.
- It gives us information about the performance of our investments, and helps us assess the success of our investment strategy.
- It helps us decide whether we should buy or sell an investment.
- It helps us analyze the risk-reward tradeoff of our investments.
What Is A Good Sharpe Ratio?
Sharpe ratios are used to measure the risk/return relationship of an asset or portfolio, as we covered above — but what makes a Sharpe ratio good? What ratio should you aim for in your portfolio?
A positive Sharpe Ratio indicates that an investor is getting more returns for each additional dollar invested, while a negative Sharpe Ratio indicates that investors are losing money for every additional dollar invested (or that the return you will get us less than the risk free investment would give you, using something such as the US treasury Bill).
In other words, a positive Sharpe Ratio shows that an asset’s return is greater than its risk. On the contrary, a negative Sharpe Ratio shows that the asset’s return falls short of its risk. A higher Sharpe Ratio means that the portfolio is outperforming government bonds. A lower Sharpe Ratio means that bonds outperform stocks, and if that’s the case the portfolio is really not good.
With this in mind, a sharp ratio of 1 is considered to be decent to good, however really this is just the barebones starting point people aim for — like getting a 70/100 on your math test in school passes you a 1 on your Sharpe ratio passes you, but it’s not really ‘good.’ A Good Sharpe ratio is around 2 to 2.5 — such a ratio is above average but not unachievable even in the long-term. A Sharpe ratio above 2.5 or near 3 is exceptional and nearly impossible to achieve long-term, if your portfolio stacks up like this over the long-term you’re truly gifted.
However – these numbers are pretty dependent on the time frame that you are measuring. If you have a portfolio, the length of time that you’ve been collecting data can alter your Sharpe ratio — typically Sharpe ratios will factor in data from their historical performance that stretches over 5 to 10 years. Keep in mind Sharpe ratios vary depending on industry and portfolio type.
Final Thoughts & Takeaways
In conclusion, the Sharpe ratio measures the risk-adjusted returns of an investment over time. It’s one of the best ways to measure the performance of your portfolio. An acceptable Sharpe ratio is considered to be anything above one – and a good Sharpe ratio is anything above two. Professional portfolios often have Sharpe ratios that are above two, and a few exceptional portfolios can even hit the 3 mark, albeit extremely difficult in the long-term.
However as mentioned before Sharpe ratios aren’t the be-all end-all of the investing world, and a portfolio with a high Sharpe ratio can still perform badly and can still not be the best for your specific investing goals/needs — it’s best to use it as an indicator, similar to P/E ratios when valuing a stock, but just like with P/E ratios you have to look into other factors of the stock (or in this case portfolio) before committing to owning it yourself.