The Sharpe ratio is a well-known and well-reputed measure of risk-adjusted return on investment, developed by William Sharpe. The Sharpe ratio can be used to evaluate the total performance of an investment portfolio or the performance of an individual stock. The Sharpe ratio indicates how well an equity investment performs in comparison to the rate of return on a risk-free investment, such as U.S. government treasury bonds or bills. There is some disagreement as to whether the rate of return on the shortest maturity treasury bill should be used in the calculation or whether the risk-free instrument chosen should more closely match the length of time that an investor expects to hold the equity investments.
To calculate the Sharpe ratio, you first calculate the expected return on an investment portfolio or individual stock and then subtract the risk-free rate of return. Then, you divide that figure by the standard deviation of the portfolio or investment. The Sharpe ratio can be recalculated at the end of the year to examine the actual return rather than the expected return.
Usually, any Sharpe ratio greater than 1 is considered acceptable to good by investors. A ratio higher than 2 is rated as very good, and a ratio of 3 or higher is considered excellent. The basic purpose of the Sharpe ratio is to allow an investor to analyze how much greater a return he or she is obtaining in relation to the level of additional risk taken to generate that return.