This article describes how you can implement the Sharpe Ratio in Excel. Often a portfolio manager will say they outperformed their Benchmark, but under the microscope, one in which risk is taken into consideration, that outperformance may not look as compelling, as we have seen here ourselves with this small 4-stock portfolio.
The S&P had decent returns, but very low volatility. It is entirely possible that a fund with a smaller Sharpe Ratio could have a sufficiently smaller Sharpe Ratio in Excel correlation with the investor's other assets that it would provide a higher expected return on assets for any given level of overall asset risk.
We can then combine our efficient portfolio with a risk free asset to create a portfolio of portfolios which we can graph as the capital market line The capital market line will lie tangent to the efficient frontier at the portfolio with the highest sharpe ratio and represent the highest expected return per unit of risk; this represents the market portfolio.
It comes with its share of caveats (namely: it's for portfolios, not stocks; don't use bad data; and if your returns are very skewed, as opposed to looking like a bell curve, it might not be so accurate), but it's a nice tool for those days when you want to sit back and really see how things are going, and think about where you might want them to go next.
If we believe that we can identify active managers with a persistent and predictable level of skill (a big if” in my opinion), then the information ratio helps us to incorporate this skill into a portfolio in a manner which maximizes the Sharpe ratio.
Covariance between returns on stocks is an important factor in this portfolio optimization because the value of diversification comes from assets that are not perfectly correlated; the greater the covariance, the more effectively we can diversify in order to reduce portfolio variability.
The Sharpe ratio was created to answer the question Given the same amount of risk, which investment provides me with the highest reward.” To do this the Sharpe ratio balances the returns in excess of a risk free benchmark with the standard deviation of the return set.
Over 25 years ago, in Sharpe 1966 , I introduced a measure for the performance of mutual funds and proposed the term reward-to-variability ratio to describe it (the measure is also described in Sharpe 1975 ). While the measure has gained considerable popularity, the name has not.