The Sharpe Ratio is a measure for risk-adjusted returns, developed by Nobel Laureate William F. Sharpe in 1966. It describes the volatility-adjusted excess returns of an asset over a risk-free return. This article highlights the thoughts behind the Sharpe Ratio formula and some practical applications of it when selecting different asset classes.
Momentum and Volatility
When describing the behavior of an asset usually two key figures are used: Momentum and volatility.
Momentum gives you an idea of how far the market has traveled over a specific observation period. Volatility describes the in-between moves of the market.
The chart below gives you an idea of the momentum and volatility of Dow Jones Industrial over the last year. Since the beginning of the year Dow Jones has been a zero-sum game, it currently is where it started. And it also showed a volatility of more than 2000 points to the up and downside. Dow Jones has not been a great investment.
The Sharpe Ratio was developed by William F. Sharpe to describe the volatility adjusted excess returns of a market. It is easily understandable when looking at the chart above. If the market made nothing over the last year, but had a volatility of more than 2000 points, it can hardly qualify as a great investment. Especially if you would have been able to get a nearly risk-free return of about 1%. With no return and a high volatility, it would even get a negative Sharpe Ratio.
Sharpe Ratio Formula
Sharpe Ratio = (annual market return – risk free return)/volatility of excess returns
The Sharpe Ratio formula is quite straight forward. It first calculates the excess return of the market over a risk-free investment. Then this number is divided by the volatility of the excess return. It basically tells you how much more than a risk-free asset the market has done over the last year, measured in multiples of market volatility instead of measuring it in points or percent returns like momentum and volatility by itself would do.
Sharp Ratio Ranking
By combining these two measurements into one figure, it becomes easy to compare different assets on an absolute basis. As the Sharpe Ratio represents the volatility adjusted returns, you can effectively compare different assets, without having to worry about the volatility of the different markets individually. If an asset has a higher Sharpe Ratio than another asset, it means that the first asset has a better return on a risk/reward scale than the second asset would have had.
To bring this to an everyday example I did a scan of different stocks on the spread sheet below. The scanner calculates the Sharpe Ratio, the Rate of Change over the last year (ROC = performance in %) and the yearly standard deviation.
The spread sheet is sorted by Sharpe Ratio. Stocks on top showing the highest rating. As you can see Abbott and Conoco both made around 30% over the last 250 trading days. But does this mean they would both have been an equally good investment?
Abbott made 30% last year and had a 17% volatility. Conoco also made 30% but showed a 26% volatility. Measured against a risk-free investment, of course Abbott is the more favorable investment. This is expressed by the higher Sharpe Ratio of Abbott versus the Sharpe Ratio of Conoco.
Sharpe Ratio and Position Sizing
Value at Risk (VAR) is a key concept in portfolio management. As its name says, VAR puts the focus not on the money invested, but on the part of the investment which is threatened by market volatility. An example: If your portfolio consists of 2 assets, you would not invest the same amount of money in both assets. A VAR-based strategy would put the same amount of risk in both assets.
For VAR-driven investors Sharpe Ratio is a good indicator to compare the performance of different assets on a volatility-normalized basis. It is nice if your stock rises by 30%, but it is even better if you find a stock which rises by 30% and only shows half of the volatility of your fist investment. The second stock’s Sharpe Ratio will be twice as high as the first stock’s one.
With a VAR-approach you would invest twice as much in the low volatility stock and therefore get a higher absolute return. Sharpe Ratio is the indicator to identify such investment possibilities.
Sharpe Ratio Indicator Code
The indicator – as shown in the chart above – calculates and plots Sharpe Ratio. When you apply it to a daily chart it uses the standard deviation of the annualized volatility of monthly returns as measure for volatility. You can change these setting on the properties page to adjust the indicator to other time frames.
Tradesignal® is a registered trademark of Tradesignal GmbH. Unauthorized use or misuse is strictly prohibited. Data by TeleTrader.