Sharpe Ratio
Sharpe Ratio
A measure of risk-adjusted return calculated as (portfolio return - risk-free rate) / standard deviation. Higher ratios indicate better risk-adjusted performance, with values above 1.0 generally considered good.
A fund returning 12% with 8% standard deviation and 2% risk-free rate has Sharpe ratio of 1.25.
Higher is better for Sharpe ratio; it rewards return per unit of risk taken.
How This Is Tested
- Calculating the Sharpe ratio given portfolio return, risk-free rate, and standard deviation
- Comparing multiple portfolios using their Sharpe ratios to identify superior risk-adjusted performance
- Identifying which inputs are needed to calculate the Sharpe ratio (distinguishing from beta-based metrics)
- Understanding that higher Sharpe ratios indicate better efficiency in generating excess returns per unit of risk
- Determining whether a portfolio with higher absolute returns also has better risk-adjusted returns
Calculation Example
Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation - Identify the portfolio return: 14%
- Identify the risk-free rate: 3%
- Identify the standard deviation: 12%
- Calculate excess return: 14% - 3% = 11%
- Divide excess return by standard deviation: 11% / 12% = 0.917
Example Exam Questions
Test your understanding with these practice questions. Select an answer to see the explanation.
Marcus, a 45-year-old investor focused on risk-adjusted returns, is evaluating three portfolios for his retirement account. Portfolio A returned 14% with a standard deviation of 18%, Portfolio B returned 10% with a standard deviation of 8%, and Portfolio C returned 16% with a standard deviation of 22%. The risk-free rate is 2%. Marcus wants to select the portfolio with the best risk-adjusted performance. Which portfolio should he choose?
B is correct. Portfolio B has the highest Sharpe ratio: (10% - 2%) / 8% = 1.00, meaning it generates 1% of excess return per unit of risk. This indicates superior risk-adjusted performance.
Portfolio A has a Sharpe ratio of (14% - 2%) / 18% = 0.67, not 0.77 as stated in option D. While Portfolio A has the highest absolute return (14%), it takes significantly more risk to achieve it. Portfolio C has a Sharpe ratio of (16% - 2%) / 22% = 0.64. Although C generates the most excess return in absolute terms (14%), it requires the most risk (22% standard deviation), making it the least efficient on a risk-adjusted basis.
The Series 65 exam tests your ability to evaluate investment performance using risk-adjusted metrics like the Sharpe ratio. Understanding that higher absolute returns don't always translate to better risk-adjusted performance is critical for making appropriate suitability recommendations, especially for clients who prioritize efficient use of risk.
Which of the following correctly identifies the components used in calculating the Sharpe ratio?
B is correct. The Sharpe ratio is calculated as (Portfolio Return - Risk-Free Rate) / Standard Deviation. It measures excess return per unit of total risk (volatility).
A describes components used in beta and CAPM calculations, not the Sharpe ratio. C describes elements related to alpha calculation and active return measurement. D includes statistical measures like correlation and variance, but these are not the direct inputs for the Sharpe ratio formula (though standard deviation is the square root of variance).
The Series 65 exam frequently tests your knowledge of performance measurement formulas and their components. Confusing the Sharpe ratio components with those of other metrics (like alpha, beta, or Jensen's alpha) is a common error. Knowing that Sharpe uses standard deviation (total risk) distinguishes it from metrics that use beta (systematic risk).
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B is correct. Calculate: Sharpe Ratio = (15% - 3%) / 12% = 12% / 12% = 1.00. This means the portfolio generates 1% of excess return for each 1% of risk (standard deviation) taken.
A (0.80) incorrectly uses 10% as the excess return (possibly using 2% as the risk-free rate instead of 3%). C (1.25) incorrectly uses 15% / 12% without subtracting the risk-free rate first, which is a common error. D (1.50) incorrectly calculates 18% / 12%, perhaps adding the risk-free rate instead of subtracting it.
Sharpe ratio calculations appear regularly on the Series 65 exam. The most common mistake is forgetting to subtract the risk-free rate from the portfolio return before dividing by standard deviation. Understanding this two-step process (calculate excess return, then divide by volatility) is essential for evaluating portfolio efficiency.
All of the following statements about the Sharpe ratio are accurate EXCEPT
C is correct (the EXCEPT answer). The Sharpe ratio uses standard deviation (total risk) in the denominator, NOT beta (systematic risk). This is a common confusion point between the Sharpe ratio and other risk-adjusted metrics like the Treynor ratio, which does use beta.
A is accurate: Higher Sharpe ratios indicate more excess return per unit of risk, signaling superior risk-adjusted performance. B is accurate: The formula (Return - Risk-Free Rate) / Standard Deviation measures excess return per unit of total volatility. D is accurate: The Sharpe ratio is particularly useful for comparing portfolios with different risk profiles because it standardizes returns based on the risk taken to achieve them.
The Series 65 exam tests your ability to distinguish between different performance metrics and their components. Understanding that Sharpe uses standard deviation (total risk) while Treynor uses beta (systematic risk) is critical for selecting the appropriate metric for evaluating diversified versus concentrated portfolios.
An investment adviser is comparing two mutual funds. Fund X has a 12% return, 15% standard deviation, and a Sharpe ratio of 0.60. Fund Y has an 8% return, 10% standard deviation, and the risk-free rate is 3%. Which of the following statements are accurate?
1. Fund Y has a Sharpe ratio of 0.50
2. Fund X provides better risk-adjusted returns than Fund Y
3. Fund X has a higher absolute return and higher risk-adjusted return
4. Both funds generate positive excess returns above the risk-free rate
D is correct. All four statements (1, 2, 3, and 4) are accurate.
Statement 1 is TRUE: Fund Y's Sharpe ratio = (8% - 3%) / 10% = 5% / 10% = 0.50.
Statement 2 is TRUE: Fund X has a Sharpe ratio of 0.60 compared to Fund Y's 0.50, indicating Fund X provides better risk-adjusted returns (0.60% of excess return per unit of risk versus 0.50%).
Statement 3 is TRUE: Fund X has both a higher absolute return (12% vs 8%) AND a higher risk-adjusted return (Sharpe ratio of 0.60 vs 0.50). This combination makes Fund X superior on both dimensions.
Statement 4 is TRUE: Both funds generate positive excess returns above the risk-free rate. Fund X: 12% - 3% = 9% excess return. Fund Y: 8% - 3% = 5% excess return.
The Series 65 exam tests your ability to calculate and compare Sharpe ratios across multiple investments while understanding the relationship between absolute returns, excess returns, and risk-adjusted performance. This skill is essential for portfolio evaluation and making informed recommendations based on clients' risk tolerance and return objectives.
💡 Memory Aid
Think "SHARPE measures bang-for-your-risk-buck": How much excess return do you earn per unit of total risk (standard deviation)? Formula: (Return - Risk-free) ÷ Standard Deviation. Higher is better, and above 1.0 means you're earning more than you're risking.
Related Concepts
This term is part of this cluster:
More in Risk & Performance Metrics
Where This Appears on the Exam
This term is tested in the following Series 65 exam topics: