The Sharpe Ratio: Why It's So Darn Important

Summary

• Individual investors typically look at their accounts in terms of profit/loss.
• For professional portfolio managers, the assumption is that they will make a profit over the long run, so they're typically measured by their return divided by the amount of volatility.
• Individual investors would greatly benefit from the way professionals approach portfolio management, to get more return for the same risk or vice versa.
• How to find your Sharpe ratio at several common brokers (or export to Microsoft Excel).
• Tips for improving your Sharpe ratio, which directly impacts your profit/loss. One way can make a bigger difference than any other investment decision you make.

(Dr. William Sharpe; source: )

Markets are constantly in flux, so it can be hard for investors to know where their performance stands purely by feel. Most individual investors look at their portfolios in terms of pure profit/loss - if they're up for the month or year they're happy, if they're down then not so much. However, for professional portfolio managers, the assumption is that they will turn a profit (or they won't be a professional for long!), so the focus instead goes to how much risk they take for each unit of return over a given time. The metrics most commonly used to measure this are the Sharpe ratio–and the information ratio, which I'll also briefly explain. My most evergreen article of all time (in terms of Google traffic) was my piece on the Sharpe ratio last year, so I'll add some extra points and address a few of the questions that readers have brought me.

The Sharpe ratio is named for its inventor, Dr. William Sharpe, who later won a Nobel Prize in economics for helping the big boys invest their money more efficiently.

Your portfolio Sharpe ratio is simply:

• Portfolio return - cash return / standard deviation

There are two elements to this so I'll touch on them both. Standard deviation is important because it's a good proxy for how rough your ride is to your final destination, and for how much time your portfolio spends in drawdown. Standard deviation is also important because it's a way to see whether you'll be forced to make tough risk management decisions. The standard deviation of the S&P 500 at large averages around 15 percent per year. The Sharpe ratio of the S&P 500 is around 0.5 over the last 25 years. You should aim to exceed it in your portfolio, otherwise, you're likely wasting your time by not indexing.

The rate of return on cash is the second element because modern portfolio theory dictates that you always have the option of keeping money in cash, or alternately borrowing money at the cash rate to invest in the markets (if you borrow money use the rate you pay in your Sharpe ratio). In 2000, standard asset valuation models showed that the S&P 500 had an expected long-run return of somewhere around 8 percent, while cash returned 6 percent. Given the inherent volatility of the market, holding cash was an excellent decision for those who made it. Then, when the Federal Reserve cut rates to zero and stocks were cheap, those same savvy investors lightened up on cash and put money to work in stocks. Without an understanding of the Sharpe ratio, you might have thought that the market would continue to shoot up in 2000 or down to the abyss in 2008.

Here's an example of an all-stock portfolio (blue), 80 stocks, 20 bonds (red), and 60 stocks, 40 bonds (yellow). All portfolios are rebalanced quarterly.

Source: Portfolio Visualizer

The best portfolio on a risk-adjusted basis is the 60/40 portfolio, followed by the 80/20. The all-stock portfolio has the highest return but the most drama. You actually can translate the superior risk-adjusted return into real money, as argued by the minds of Cliff Asness, Pietros Maneos, Dane Van Domelan, (and me). You can take the execution much further, but all you have to do is use the right ETFs and futures and you can make it happen, too.

As illustrated above, the Sharpe ratio adds analytical value as it allows a better comparison for investors who aren't 100 percent in stocks. By the very virtue of owning bonds, you will lower your raw expected rate of return. The Sharpe ratio gives you a cleaner benchmark to compare your performance against the market. If you're 70 percent stocks and 30 percent bonds, matching the S&P 500 return with less risk is a job well done! Investors who are 100 percent in stocks often use the information ratio instead, which uses how much you beat or lose to the market by divided by your tracking error. If so, you may prefer it (the IR is typically used more for mutual fund managers).

How to find your Sharpe ratio

I use Interactive Brokers and Etrade for trading. I'll show you how to find your account Sharpe ratio in each, as well as create a general guideline for other brokers.

Interactive Brokers: Interactive Brokers Web Trader Login >Portfolio Analyst > Reports > Create Custom Report.

Then you'll pull your portfolio's results for as long as is practical, selecting "risk measures," and all the performance statistics they'll let you. Then you should be able to find your portfolio's Sharpe ratio and compare it to the S&P 500.

Etrade: Login > Accounts > Portfolios > Performance & Value > Download (top right by the print icon).

Etrade is a little trickier, I'm not aware of any direct way to look up your Sharpe ratio. This is the case for most brokers, but you can easily export Etrade's results to Microsoft Excel to calculate. Here's a template to look up your Sharpe ratio with exported data (here's another). Speaking of Microsoft Excel, spreadsheets were never a strength of mine, but Excel is the language of investing, so I highly recommend getting at least a little comfortable with it.

Other Brokers: Vanguard is the other most popular broker that my readers use. To the best of my knowledge, you should be able to export your portfolio performance to Excel through a similar fashion to how you can with Etrade. The more trader focused your broker is, the higher the odds are that you can simply download a report.

Portfolio Visualizer:

If you've exported your performance data to Microsoft Excel, you should be able to import it to Portfolio Visualizer. For those of you who are tech-savvy, this can save a lot of time.

How to Improve Your Sharpe Ratio And Your Returns

Finance theory says that if you can improve your Sharpe ratio, you can translate it into superior returns by using leverage (or holding less cash). If your head is spinning don't worry, it takes a little while to get familiar with the concepts, but you'll be glad you know about this because it's literally the one thing that is the most likely to help your wealth 20 years down the road.

1. Diversification (duh). The typical ETF has a higher Sharpe ratio than the typical individual stock. This is because owning only a few stocks exposes you to idiosyncratic risk. The typical stock has a median return of 5 percent per year and volatility of somewhere around 40 percent (Sharpe ratio of less than 0.1, 1/5 of the market!).

Source: Investopedia

Early in my investing career, I exclusively picked stocks. I made great money over time, but with constant drama and volatility. Diversification works two ways, it buffers you from idiosyncratic risk, but what many people don't realize is that diversification makes sure that you have a piece of the big winners that drive the broader market returns. Diversifying across asset classes can further improve your investment returns. Portfolio theory says that you should improve your investment returns per unit of risk by the square root of the number of uncorrelated investment opportunities that you have available to you.

2. Don't fight the Fed. While it seems cliché to tell people not to fight the Fed, half of the Sharpe ratio is your portfolio return and half is the cash return. If cash returns zero, you can make money over time buying stocks or bonds with yields that far exceed the ~1 percent you can borrow for at a professional broker (if you manage risk correctly). Alternately, you can sit some of your assets in cash and Treasuries when cash returns rise and buy back in near the bottom. This is the main point of modern portfolio theory as theorized by William Sharpe himself. An interesting corollary to this is that if you know the theory, you can typically beat the returns of almost all of the talking heads on TV with nothing more than access to cheap leverage and sufficiently diversified ETFs and futures.

Source: Johnew Zhang via Github

See how steep the line is here? That's the model telling you to load up on stocks when interest rates are low and equities are depressed (the present time is a little more complicated due to the massive stimulus but the basic ideas hold).

3. Pay attention to volatility

Research shows that stocks that have higher volatility tend to perform worse on a risk-adjusted basis than those with low volatility. Other research shows that during calm periods for the S&P, risk-adjusted returns are higher. You can't manage what you don't track, so tracking the performance of your portfolio as well as the volatility helps to understand risk. Another thing that will drag down your Sharpe ratio– commissions, fees, bid/ask spreads, and margin interest in excess of the risk-free rate.

Limitations of the Sharpe Ratio

Some less-than upstanding fund managers are skilled at manipulating Sharpe ratios to pull in money. As a general rule, if you're selling longshot risks, your Sharpe ratio won't reflect risks that didn't occur. This happens most commonly in funds that sell deep out of the money options, which will win a small amount of money 3-4 years straight each month, then pay out the vast majority of the profits in one or two bad months. This is an obvious conflict of interest if the manager is paid a cut of the profits.

Alternately, value investing may have volatility that overstates its true risk. If you've done your homework on a stock that's trading for 80 cents on its book value with a high earnings yield, it may bounce up and down, but you're unlikely to see a 50 percent sustained fall.

In all, however, the Sharpe ratio is a very good measure of portfolio risk. Taking the time to understand the ratio will help you invest your money better for the rest of your life!