## What is Sharpe Ratio?

The **Sharpe Ratio** is the risk-adjusted return of a portfolio measured by dividing the excess return by the standard deviation of the portfolio.

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## How to Calculate Sharpe Ratio

The Sharpe ratio evaluates the risk-adjusted performance of an investment portfolio by determining the excess return received for the extra risk/volatility associated with a riskier portfolio.

Economist William Sharpe came up with the Sharpe ratio as well as the CAPM model.

Investors can determine the risk-adjusted returns by assessing the excess returns earned over the risk-free rate.

A core principle of valuation theory is that investors should receive more compensation for the incremental risk of holding a risky asset, rather than a risk-free asset.

If not, the investor has made an irrational choice, as the same return could have been obtained without the added risk.

The steps to calculate the Sharpe ratio are as follows:

- Step 1 → First, the formula starts by subtracting the risk-free rate from the portfolio return to isolate the excess return.
- Step 2 → Next, the excess return is divided by the portfolio’s standard deviation (i.e. the proxy for portfolio risk).

If we put the steps from the prior section together, the formula for calculating the ratio is the difference between the expected portfolio return and risk-free rate, divided by the standard deviation of the portfolio.

**Sharpe Ratio =**(Rp

**−**Rf)

**÷**σp

Where:

- Rp = Expected Portfolio Return
- Rf = Risk-Free Rate
- σp = Standard Deviation of Portfolio (Risk)