Sharpe Ratio Explanation

The Sharpe Ratio

Personally, a company’s or fund’s Sharpe ratio is incredibly telling of their overall performance – especially when you have a benchmark to compare it to. In one of our more recent releases we added this ratio as a standard piece of information that is given back to you in the backtest report. That’s all fine and well, but what exactly is the Sharpe ratio?

The Sharpe Ratio is a ratio that compares the returns made by the strategy to the risk of that strategy. If a company’s share price went up 600% in a year, that’s great, but did it bounce between 600% and -600%, making it an extremely risky investment? This idea of comparing returns to risk becomes even more valuable when you compare the Sharpe ratio of a strategy to that of the S&P 500, the standard benchmark in the Equities Lab system.

Here is a screenshot of the backtest report of one of my personal strategies “Low Price, and Low Volatility.” It looks for small cap companies that have a low probability of changing in price drastically. As you can see, the Sharpe ratio for this strategy is 0.2615 compared to the S&P’s 0.1645 (The higher the ratio the better).

How it’s calculated

(Monthly Return-Risk Free Return)/Standard Deviation=Sharpe Ratio

A Sharpe ratio can be calculated on any time frame, we just happen to use monthly numbers in our system. In the event that you want to calculate it on an annual basis, just create a new tab called “plot_sharpeRatio” and import the Sharpe Ratio Annual into the editor under that tab.

The Sharpe Ratio Annual Formula takes the change of the share price over the past year and subtracts the standard risk free interest rate of 2%. It then divides that number by the standard deviation of the change of the share price over the past year.

This will plot the annual Sharpe ratio for every stock in your screener, as well as for your entire strategy rebalanced on whatever scale you set.

Here we are taking a look at a screen that has a performance that roughly mirrors that S&P 500. However, it mirrors the performance at double the standard deviation over the past twenty years – resulting in a much lower Sharpe ratio, which suggests that there is a far higher risk to investing in this strategy than the S&P.

Not surprisingly, the Sharpe ratio is half that of the market, making it appear that the S&P is the much better investment in this situation. While, on the other hand, the “low price and low volatility” screen we discussed, and showed, earlier has a Sharpe ratio higher than the overall marketing – suggesting that, in that case, it would be better to invest in the strategy rather than the S&P.

Now Sharpe ratios aren’t constant. Actually, the only thing constant about them is that they are constantly changing. If a company has a major spike in any which direction the Ratio is going to be affected greatly as the company’s volatility will increase significantly. Because of this the Sharpe ratio shouldn’t be the only thing you look at when it comes to deciding whether or not to implement a new strategy in your portfolio. Instead, it should just be a piece of the much bigger analysis puzzle.

For more information on the Sharpe Ratio, head over to the link below where you can delve into the history and proof behind the it.