What is the Sharpe ratio?

Accounting Dec 18, 2020

Expert Solution

The Sharpe ratio is a tool to assess and investment developed by William F. Sharpe.

The Sharpe ratio takes the expected return of a risky investment and subtracts the return on a risk-free investment and then divides by the historical volatility of the risky investment. If an investor is considering a stock that has an expected return of 12% with a volatility of 20% and they know that that the return on a risk-free investment is 3.5%, the Sharpe ratio is found by conducting the following equation:

(12% - 3.5%) / 20%

This reveals a Sharpe ratio of 42.5% which can be compared to other investments. The higher the Sharpe ratio, the safer the return is assuming that past performance is indicative of future results.

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