Advisor Blog

In a discussion with Scott Maxwell yesterday about fixed income choices for the portfolio of one of his clients, we found that we made frequent references to the Sharpe Ratio of the fixed income funds and the portfolio design. This lead us to wonder how many clients or prospective clients really understand this important risk/return measurement.

The Sharpe Ratio is named after William Sharpe, winner of the Nobel Memorial Prize in Economic Sciences for his work on the Capital Asset Pricing Model (CAPM - more about that in a future post). The ratio describes how much excess return is generated by a portfolio in exchange for the additional volatility of the portfolio that the investor must endure. The point is that an investor must be properly compensated for bearing additional risk beyond that of a risk-free asset.

S(x) = (rx-Rf) / std dev (x)

This formula describes the calculation where the Sharpe Ratio of the portfolio is equal to the average rate of return for the portfolio minus the risk free rate of return (usually short-term T-bills) divided by the standard deviation of the portfolio.

Why is this so important? Because it describes the efficiency of the portfolio - how much return is generated for each unit of risk taken. Obviously, a higher number is better. This allows us to compare the performance of a portfolio to another that takes more or less risk. It also allows us to maximize the efficiency of portfolio designs.

Consider two portfolios with identical returns. One is riskier than the other. A rational investor would always choose the least risky portfolio with the same return. Conversely, consider two portfolios with identical risk. One has a higher return. A rational investor would always choose the portfolio with the highest return. The Sharpe Ratio provides a method for calculating this risk/return tradeoff.