Look sharpe
The Sharpe ratio measures return on a risk-adjusted basis by comparing
an investment's return to the return on the one investment
that's considered essentially risk free: the 13-week (or
90-day) U.S. Treasury bill. The bill is guaranteed by the full faith
and credit of the U.S. government, making it virtually free of
default risk, and it matures in such a short period that it's
also considered free of inflation risk.
To calculate the ratio, which evaluates return per unit of risk,
you subtract the return on a 13-week bill from an investment's
return and divide the result, called the excess return, by the
investment's standard deviation. The higher the ratio is, the greater the potential
for a strong return. For example, if the excess return was 7%
and the standard deviation was 1.5, the ratio would be 4.66. But
if the standard deviation was 2.5, the ratio would be lower, at
2.8, and the risk would be higher.
Like other measures, the Sharpe ratio reports what the risk has
been in the past for investment categories, such as large- and
small-company stock or a specific type of bond. That data can
be helpful in making allocation and diversification decisions
in light of your risk tolerance and financial goals.
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Thomas J. Dorsey, President and
co-founder of Dorsey, Wright &
Associates 