What is Sharpe Ratio?

The Sharpe ratio measures how much return an investment delivers for each unit of risk taken. It compares the extra return earned over a risk-free option with the ups and downs of the investment’s returns. A higher value suggests that the investment delivered potential returns for each unit of risk, while a lower value signals that returns may not justify the risk taken. This metric is widely applied in portfolio analysis and fund evaluation. This article explains what is sharpe ratio in mutual funds. 

Sharpe Ratio Formula 

The Sharpe ratio formula is: 

Sharpe Ratio = (Rp – Rf) / σp  

Where: 

• Rp = Return of the portfolio 
• Rf = Risk-free rate of return 
• σp = Standard deviation of the portfolio (measure of total risk) 

Example 

Suppose: 

• Portfolio return (Rp) = 12% 
• Risk-free rate (Rf) = 6% 
• Standard deviation (σp) = 8% 

Sharpe Ratio = (12 − 6) / 8 = 6 / 8 = 0.75 

This means the portfolio generates 0.75 units of excess return for every unit of risk taken. 

How to Calculate the Sharpe Ratio?  

After understanding the Sharpe ratio meaning and formula, let's understand how to calculate the same: 

Step 1: Calculate Portfolio Return  

Determine the average return generated by the investment over a specific period. 

Step 2: Identify the Risk-Free Rate  

Use the yield of government securities such as Treasury Bills. 

Step 3: Find the Excess Return  

Subtract the risk-free rate from the portfolio return. 

Step 4: Measure Standard Deviation  

Calculate the standard deviation of portfolio returns to assess volatility. 

1. Step 5: Apply the Formula 

Divide excess return by standard deviation. 

The final value represents the risk-adjusted return of the investment. 

What is Considered a Good Sharpe Ratio? 

The table below explains what a good Sharpe ratio is  

Why is the Sharpe Ratio Important in Investment? 

The Sharpe Ratio in mutual funds is important for the following reasons: 

• Compares investments with different risk levels 
• Highlights whether returns come from skill or extra volatility 
• Aids portfolio comparison on a like-for-like basis 
• Supports asset allocation decisions 
• Tracks the consistency of returns over time 

Advantages and Disadvantages of the Sharpe Ratio 

The following table highlights the advantages and disadvantages of the Sharpe ratio 

Conclusion 

The Sharpe ratio definition explains how returns relate to risk, and it supports fund selection, portfolio review, and performance checks across market phases. While it does not reflect every risk, it offers a steady base for comparison. When analysing portfolios through a share trading app, the Sharpe ratio helps investors see whether returns justify the risk taken. Using it wisely can improve long-term investment planning.