Reward and risk are constant concerns of investors. A useful tool for analyzing return on investment versus risk is the Sharpe ratio. The name comes from Nobel laureate William F. Sharpe who developed this investment tool. The ratio shows us the excess returns in a portfolio when compared to risk-free assets. This measure is then looked at as a part of total risk or volatility. Investors would prefer that their portfolio has a higher than average Sharpe ratio. To maximize Sharpe ratio in a portfolio one needs to continually analyze performance.

Sharpe Ratio Portfolio Optimization

There are formulas for Sharpe ratio portfolio optimization and they are complicated. However, if you want to increase the returns in your portfolio relative to the risk that you are willing to take you do not need to be a mathematical genius or spend all of your time calculating these ratios. Basically, if you are willing to accept more risk in your portfolio you need to pick stocks that provide better returns. If you wish to avoid excessive risk you can accept lower returns but only to a point. The Sharpe ratio gives you a good idea of how well you are doing when comparing risk to returns but you still need to look at every investment and apply common sense!

Sharpe Ratio of S&P 500

The higher the Sharpe ratio of an investment the better it is when adjusted for risk. At the end of May, 2022, the S&P 500 Sharpe ratio is terrible at 0.01. Any ratio from zero to 1.0 is less than optimal. One should not be surprised at this result as the S&P 500 has fallen more than 13% year to date and would have been down 16% except for a pre-Memorial Day rally. Because the Sharpe ratio uses a three-year time period in measuring risk-adjusted returns the number is better than if it had been calculated for just 2022.

Average Sharpe Ratio for Hedge Funds

Hedge funds are typically riskier investments. Thus, in order to get a good Sharpe ratio, they need to produce higher returns than the average portfolio. Unfortunately for many hedge fund investors, the average Sharpe ratio for hedge funds runs between 0.299 and 0.304 which is less than the 0.342 to 0.362 ratio of a randomly chosen portfolio. The sad fact is that when the market is going up all ships rise and those who trust their money to a hedge fund often see nice returns. Then the market falls and your hedge fund leads the plunge.

Is a Higher Sharpe Ratio Better?

In general, a higher Sharpe ratio is better than a lower one. However, there is far more to successful investing than following your Sharpe ratio. A good first step when investing is to decide how much risk you are willing to accept. As a rule, younger investors can accept greater risk because they will have more time to make up losses. Those investors approaching or in retirement generally stick with lower risk. Within your risk category you will want to have a higher Sharpe ratio rather than a lower one.

Sharpe Ratio Negative

Because a higher Sharpe ratio is always better than a lower one, a negative rate is a bad thing. You get a negative Sharpe ratio if your portfolio returns are negative or when your portfolio return rate is lower than the risk-free rate. If you have lost money in your portfolio, you do not need a Sharpe ratio calculation to tell you that is a bad thing. But, when your rate of return is less than that of risk-free investments you need to rethink your approach to investing and your individual stock picks.

Optimal Portfolio Sharpe Ratio

Your optimal portfolio Sharpe ratio will be the highest that you can get. Anything below 1.0 is not good. Anything above 1.0 is good. Above 2.0 is very good and above 3.0 is excellent. When assessing the returns of your portfolio you need to decide how much risk you are accepting and look at your returns on a risk-adjusted basis. Thus, you may be looking at a different optimal portfolio Sharpe ratio of a low-risk portfolio than for a high-risk one.

Max Sharpe Ratio Portfolio Optimization

Investors like Warren Buffett typically have portfolios with high Sharpe ratios. However, they do not pick stocks based on Sharpe ratio calculations. Rather they choose investments that they understand, investments likely to produce growing returns for years and years. These investments generally result in optimal Sharpe ratios. Buffett’s investment of billions in Coca Cola in the late 1980s was based on the belief that its strong brand name and line of products offered both a margin of safety and an expectation of long term growth. That was an excellent investment unrelated to any Sharpe ratio calculation.