So you’re generating high returns in your personal account and now you want to become a master of the universe. I’m just kidding. I’m not even master of my own domain. Besides, there’s only one master of the universe, and that’s He-Man. Unfortunately this post isn’t about He-Man. It’s about the Sharpe ratio.
Before I started working at a hedge fund, the sole focus in my portfolio was how much return I could generate. I wasn’t worried about diversification, hedging risk, or even thinking about factor exposures. All I was focused on were stocks that would go up, and the higher the better. Don’t get me wrong. That’s a good thing to focus on. Your only goal in investing is to make money. But if you’re generating high returns, maybe you’re not as good of an investor as you think you are. Maybe your returns are higher not because you’re smarter than everybody else, but because you’re taking on a lot of risk? This is where the Sharpe ratio comes in. It measures your risk-adjusted return to determine whether you’re actually a good investor, or one that just takes more risk than others.
What’s Your Sharpe Ratio?
Since working at a hedge fund, I now realize that returns are only one part of the equation. Many institutional investors like to look at the Sharpe ratio because it gives you a risk-adjusted return. This way, they can compare different managers on a risk-adjusted basis to see who’s actually generating sustainable alpha and who’s just taking on a lot of risk.
Institutional investors, who are my clients, also want low volatility returns. You and I can stomach a lot of volatility in our personal accounts because it’s excess capital. If we have a big loss, it just means that we need to wait longer to buy what we were saving up for. Instead of retiring early, you may need to work a few more years. Instead of putting that down payment on a how, you may need to rent for another year.
Institutional investors, such as pension funds and endowments, don’t have that luxury. First, they’re dealing with tens or hundreds of billions of dollars. So any large percentage move adds up to really large numbers. Second, they also have large commitments, such as pension payments. It doesn’t matter Whether returns are strong are weak, they still need to fulfill their pension obligations. You can’t tell a pensioner that the money you promised them will be lower this year because returns were weak. Pension funds have consistent outflows and they want consistent returns to match.
Imagine you were investing your funds to pay your mortgage or rent. Yes, it’d still be great to knock it out of the park and generate massive returns. But what if you lost so much money in a month that you couldn’t afford your rent or mortgage? With enough negative months, you would get evicted and then become homeless. Because of the downside risk, you’d be much happier with a lower, more consistent return. This is what it’s like for pension funds and other large institutional investors.
How to Calculate Your Sharpe Ratio
The equation for the Sharpe ratio is the return of your portfolio, less the risk-free rate (around 1% right now), all divided by the standard deviation of your portfolio.
You subtract the risk-free rate from your portfolio return because there’s always an opportunity cost to capital. If you didn’t invest that money, you could have put it into a risk-free investment and generated some level of return. That’s why the numerator is your excess return – it’s in excess of the risk-free rate.
On the denominator is the standard deviation. A quick refresher on statistics – yay! Standard deviation is a measure of dispersion around the mean. A higher standard deviation means there’s more variability in the data. In a dataset with normally distributed data, 1 standard deviation will encompass 68% of all results. If you have a dataset with 100 monthly returns, 68% of those returns should fall within 1 standard deviation from the average. 2 standard deviations will cover 95%, while 3 standard deviations will cover 99% of results.
How to Calculate Your Sharpe Ratio on a Monthly Basis
This is the formula to calculate your Sharpe ratio on an annual basis. If you’re looking to calculate it using your monthly returns, you’ll need to average your monthly returns in excess of the risk-free rate, divide by the standard deviation of your monthly returns, and then multiply everything the square root of 12.
Here’s an example below:
The returns are on a per-month basis. The risk-free rate is just the annual risk-free rate (1%) divided by 12 to get to a monthly number. The delta is the monthly return less the risk-free rate. The average monthly return is just the average return for all the months, while the standard deviation is calculated using the STDEV function in Excel.
If you simply sum the monthly returns, this portfolio returned around 14% annually, which is pretty good by most standards. However, the Sharpe is just under 1. Why? It’s because the returns are inconsistent. There are a lot of months were returns are positive, but there are a lot of months where returns were negative as well. Those down months are what scare away institutional investors.
What’s A Good Sharpe Ratio?
If you have a Sharpe ratio of 1, that means you’re generating a return commensurate with the risk you’re taking. If you have a Sharpe ratio above 1, that’s good because it means that you’re generating a return above the additional risk you’re taking. A level above 2 is extremely good. That means you’re generating returns 2 times better than what the volatility implies you should be generating. If you’re above 3, you’re killing it. If you can consistently generated a Sharpe ratio above 3 for an extended period of time, you really need to consider starting your own hedge fund. I’d invest with you.
If you’re below 1, think about how you’re investing. You may be generating returns above the market, but it’s because you’re taking excess risk. This investing strategy is fine in a bull market, but the market turns, you’ll probably get crushed.