- Tax Planning
- Investments 1: Before you Invest
- Investments 2: Your Investment Plan
- Investments 3: Securities Market Basics
- Investments 4: Bond Basics
- Investments 5: Stock Basics
- Investments 6: Mutual Fund Basics
- Investments 7: Building Your Portfolio
- Investments 8: Picking Financial Assets
- Investments 9: Portfolio Rebalancing and Reporting
- Retirement 1: Basics
- Retirement 2: Social Security
- Retirement 3: Employer Qualified Plans
- Retirement 4: Individual and Small Business Plans
- Estate Planning Basics
Sharpe Measure
Sharpe Measure
The Sharpe measure is a ratio of your portfolio’s excess return divided by your portfolio’s standard deviation. The portfolio’s excess return is found by subtracting the risk-free rate (the rate of return you are guaranteed to make with limited risk) from the amount of the portfolio’s actual return. The risk-free rate is considered by most investment professionals as the amount of return you receive on a six- or twelve-month Treasury bill. Since these bills are default free (because the government can always print more bills) and since their return is nearly guaranteed, they are considered a proxy for the risk-free rate or the benchmark over which all other financial or real assets are compared. The difference between an asset’s return and the risk-free rate is called the risk premium, or excess return. The Sharpe measure is calculated as follows:
(rp – rf ) / sp
In this equation, rp = the average return on the portfolio; rf = the risk-free rate; and sp = the standard deviation of portfolio return. The Sharpe measure is found by dividing the portfolio risk premium, or the return on the portfolio minus the risk-free rate, by the standard deviation of the portfolio.
An asset’s Sharpe measure in isolation means little. It must be measured against the market’s Sharpe measure. The market Sharpe measure is calculated the same way, by dividing the market risk premium, or the return on the market minus the risk-free rate by the standard deviation of the market. If the asset’s Sharpe measure is greater than the market’s Sharpe measure, the asset has outperformed on a risk-adjusted basis.
