The Sharpe Ratio, created in 1966 by Nobel laureate William F. Sharpe, is an equation to calculate risk-adjusted performance of a stock portfolio. The ratio determines whether a portfolio's profit can be attributed to correct thinking or high risk. The higher the ratio, the better the portfolio has performed after being adjusted for risk. While a certain portfolio may generate a great profit, that profit may be the result of huge and potentially dangerous risk. The exact calculation for the ratio requires subtracting the rate of a risk-free investment from the expected portfolio return, divided by the portfolio's standard deviation:

(rate of portfolio return - risk free rate) / portfolio standard deviation

- Skill level:
- Moderate

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## Instructions

- 1
List the annual returns of your portfolio. If your portfolio is five years old, begin from the first year. For example:

2005: 12 per cent

2006: -3 per cent

2007: 9 per cent

2008: -8 per cent

2009: 6 per cent

- 2
Calculate the average of portfolio returns by adding up each return percentage and dividing by the number of years.

For example: 12 + -3 + 9 + -8 + 6 = 3.2

This is your portfolio's average return.

- 3
Subtract each year's individual return from average portfolio return. For example:

2005: 3.2 - 12 = -8.8

2006: 3.2 - -3 = 6.2

2007: 3.2 - 9 = -5.8

2008: 3.2 - -8 = 11.2

2009: 3.2 - 6 = -2.8

- 4
Square the individual deviations.

For example:

2005: -8.8 x -8.8 = 77.44

2006: 6.2 x 6.2 = 38.44

2007: -5.8 x -5.8 = 33.64

2008: 11.2 x 11.2 = 125.44

2009: -2.8 x -2.8 = 7.84

- 5
Find the sum of each year's squared deviation.

For example: 77.44 + 38.44 + 33.64 + 125.44 + 7.84 = 282.8

- 6
Divide the sum by the number of years minus one.

For example: 282.8 / 4 = 70.7

- 7
Calculate the square root of this number.

For example: 8.408

This the annual standard deviation of the portfolio.

## Average Return and Standard Deviation

- 1
Place your three numbers into the Sharpe Ratio equation.

- 2
Subtract the rate of risk-free return from the rate of return for the portfolio.

For example: (Using the previous numbers and the rate of return on a five-year US government bond) 3.2 - 1.43 = 0.3575

- 3
Divide by the standard deviation.

For example: 0.3575 / 8.408 = 0.04252 (approximate)

This is your Sharpe Ratio.