How to Properly Use the Sharpe Ratio (According to Dr. Sharpe Himself)

Most investment professionals are familiar with the formula known as the Sharpe Ratio. The calculation is so omnipresent in financial circles that it even features as a sales objection on the television series “Billions”: “My people have a few questions. Your Sharpe Ratio’s very low.”

The power of the Sharpe Ratio is what it conveys in one simple number—incremental investment reward per unit of risk. Or said more colloquially, it communicates how much bang investors are getting for the bucks they risk.

There are several variations of the Sharpe Ratio. But for this column let’s think of it as [average portfolio returns – the risk-free rate] / standard deviation, where “excess return” is calculated in the numerator as the average of portfolio returns for a given period, like a month or a year, minus the risk-free rate (usually, Treasury bills). The denominator is the standard deviation of excess return, and the resulting quotient is the Sharpe Ratio. The bigger the number, the better the risk-adjusted performance.

But guess again if you think funds with high Sharpe Ratios are all it takes to build client portfolios.

I recently sat down with the ratio’s namesake, Nobel laureate and Stanford University finance professor emeritus Dr. William Sharpe. I asked him to put himself in the shoes of a financial adviser and explain the right way to use his calculation.