What is Sharpe Ratio?
Sharpe Ratio measures your ability to create a larger return than your volatility.
A principle of investing is that there is a connected relationship between generating returns (profit) and taking risks. Sharpe Ratio is a formula that measures whether your returns are large enough to compensate for the amount of risk you are taking.
Sharpe Ratio - The Math
Sharpe Ratio Formula = (Average Portfolio Returns – Risk-Free Rate) ÷ Volatility
Where:
Average Portfolio Returns: The average of all your daily returns
Risk-free rate: The Daily return of the 3-month US Treasury Bill
Volatility: Standard deviation of daily portfolio returns
We built this calculator to help you visualize it better:
Tips to Keep in Mind
Tip #1: Remember that Sharpe Ratio uses your "average return" not your total returns. This means that how you perform each day matters. Set daily goals.
Tip #2: Master volatility. The volatility of your portfolio is easier to predict and control than the potential returns of your portfolio. If you can actively manage your volatility you are halfway through maximizing your Sharpe ratio.
Tip #3: Aim for consistency over one-time large gains. Sharpe Ratio rewards those who have a consistent pattern of generating returns over those making money due to a few big decisions.
Performance Goals
Professionals should be able to generate a Sharpe Ratio of 2. On EquitySim aim for a Sharpe ratio that is greater than 0.5. This will not be a simple challenge, as less than 0.1% of EquitySim users can do this consistently.
note: Sharpe Ratio less than - 5.0, and greater than 5.0 is considered as system miscalculations and will show us as N/A.
To learn more about Sharpe Ratio you can reference these articles: