If you want to estimate the expected return on the portfolio based on the beta, use the CAPM Calculator. The CAPM calculator will tell you the expected return of the portfolio, which you can input above.
The risk-free rate is usually the rate of a government bond, such as a 30-year Treasury Bill.
You can compare the expected return of the portfolio against common market benchmarks like the S&P 500, Dow Jones, and Russell 2000.
|Benchmark||Historical return||Time period of return|
|S&P 500||7.96%||1957 to 2018|
|S&P 500||5.90%||1999 to 2019|
|Dow Jones Industrial Average||5.42%||1896 to 2018|
|Russell 2000||7.70%||1999 to 2019|
|MSCI EAFE||4.00%||1999 to 2019|
The Sharpe Ratio is an investing metric used to evaluate the performance of a portfolio, after adjusting for its riskiness. It is a reward-to-risk ratio.
It is defined as the difference between the returns of the investment and the risk-free return, divided by the standard deviation of the investment returns. It represents the additional amount of return that an investor receives per unit of increase in risk.
The Sharpe Ratio formula is:
Let's breakdown the formula. We will look at the numerator first.
The numerator represents the excess return of the portfolio. Excess means above the risk-free rate, which is usually the rate of a government bond, like the 30-year Treasury bill.
The Sharpe Ratio increases when the excess return of the portfolio increases.
Now, let's look at the denominator, which is the standard deviation of the portfolio. A higher standard deviation represents a more risky portfolio, and therefore, reduces the Sharpe Ratio. Conversely, a lower standard deviation represents a less risky portfolio, and thus, increases the Sharpe Ratio.
The Sharpe Ratio is highest when the expected portfolio is higher and the portfolio standard deviation is low.
|Sharpe Ratio range||Interpretation|
|< 1.0||Subpar portfolio return|
|> 1.0||Acceptable returns given risk|
|> 2.0||Strong portfolio returns|
|> 3.0||Exceptional risk-adjusted returns|
The Sharpe Ratio measures risk by using the standard deviation of the portfolio, which assumes a normal distribution of risk. However, financial assets are often not normally distributed. For example, Ponzi schemes will have a highe Sharpe Ratio until they collapse. The Sharpe Ratio does not properly capture assets with a black swan risk. Black swans are unpredictable events with potentially catastrophic consequences.