Invented in 1966 and refined in 1994 by Nobel laureate William F. Sharpe, the Sharpe Ratio is a simple mathematical formula investors use to compare the risk of an asset or investment to the success of its return. Although its detractors claim that it oversimplifies risk, the Sharpe Ratio has been popular among day traders and investment firms alike for many years due to its comprehensibility and intuitive application.

Despite the ratio's popularity, it does have a few glaring weaknesses; most importantly that it relies on an asset's standard deviation to assess its risk. Whenever the asset's returns don’t follow a normal distribution, the ratio's validity suffers. As long as investors keep this in mind, it’s generally a reliable and accurate tool. To use it wisely, you'll need to know the Sharpe Ratio list of variables it takes into account, such as:

1. An asset's average rate of return is the amount of money an investor receives for holding the asset over a certain period of time.

2. The risk-free rate of return is the best available rate an investor can find on a secured asset, normally a government Treasury Bill, or T-bill.

3. The final piece of the ratio is the standard deviation of the asset's average rate of return.

Action Steps
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Understand how the Sharpe Ratio works

Contrary to what some investors believe, the Sharpe Ratio is in fact very easy to calculate. To calculate the Sharpe Ratio, begin by subtracting the rate of risk-free return from your asset's average rate of return. This number is almost always positive and becomes larger as your asset becomes more successful. Then, divide this difference by the asset's standard deviation. The resulting quotient is your asset's Sharpe Ratio.

I recommend: Find Sharpe Ratio information at Investopedia, which publishes articles and encyclopedic entries on a wide range of investment topics. If you're interested in learning more about the math behind the ratio, check out William F. Sharpe's homepage on the Stanford University website.

Apply the Sharpe Ratio to your investments

To use the ratio to assess the risk of your investments, you'll need to first find their average rates of return and standard deviations. If you keep track of your portfolio, then you probably know where to find this information. If you have trouble locating it, however, there are a variety of free tools online that give you detailed statistical information about specific stocks and funds.

I recommend: Purchase Treasury Bills and other risk-free assets from government auctions held through Treasury Direct. To find your stock or fund's statistical information, including its standard deviation, you can try either the Stock Screener from MSN Money or the Fund Screener from Morningstar.

Use the Sharpe Ratio to make smart investment decisions

If your investments have posted rapid growth over a recent period of time, they may be reasonably outperforming the market. They may also, however, be taking on too much risk to achieve these gains, exposing your portfolio to a potentially devastating loss. By calculating the Sharpe Ratio of your assets and other competing assets, you can decide which one best suits your investing personality and long-term financial goals.

I recommend: For general advice on the role of risk in investing, consider William F. Sharpe's book "Investors and Markets," which offers a holistic perspective on comparing investments, evaluating portfolios and making wise financial decisions. You can also use a research engine like MarketWatch to find the information you need to make educated investment assessments.

Tips & Tactics

Helpful advice for making the most of this Guide

• •  Try to find a graphical representation of your asset's returns before using the Sharpe Ratio to calculate its risk. If the asset's returns don't have a bell-curve distribution, consider using other methods to assess its risk.
• •  Ask your financial advisor about using the Sharpe Ratio. Providers of investment services may have unique ways of using the ratio that can help you manage your portfolio's risk.