The Sharpe ratio measures return per unit of risk — how much excess return you earn for each unit of volatility you accept. It helps compare portfolios on equal footing: a lower-return portfolio with much lower volatility may have a superior Sharpe ratio, meaning it uses risk more efficiently.
The Sharpe ratio is a measure of risk-adjusted return developed by Nobel laureate William Sharpe. It is calculated as the portfolio's excess return (above the risk-free rate) divided by its standard deviation. A higher Sharpe ratio means more return per unit of risk taken.
How It Works
Sharpe Ratio = (Portfolio Return − Risk-Free Rate) / Portfolio Standard Deviation
For example, comparing two portfolios:
| Portfolio | Return | Volatility | Risk-Free Rate | Sharpe Ratio |
|---|---|---|---|---|
| Aggressive (90/10) | 9.5% | 18% | 2% | 0.42 |
| Balanced (60/40) | 7.5% | 10% | 2% | 0.55 |
The balanced portfolio has a higher Sharpe ratio despite lower returns — it earns more per unit of risk. This matters for retirement because unnecessary volatility increases variance drain and sequence-of-returns risk without proportionally increasing returns.
Why It Matters for Retirement Planning
The Sharpe ratio helps answer a key asset allocation question: "Am I being compensated for the risk I'm taking?"
For retirees, risk efficiency matters more than raw returns because:
- Variance drain means higher volatility reduces compound growth even with the same average return
- Sequence-of-returns risk makes drawdown-phase portfolios more vulnerable to volatility
- Diversification across correlated asset classes improves the Sharpe ratio by reducing portfolio volatility more than it reduces returns
However, the Sharpe ratio has limitations: it treats upside and downside volatility equally, doesn't capture skewness or kurtosis, and only measures risk-adjusted return — not whether the absolute return is sufficient to fund retirement.
Frequently Asked Questions
- What is a good Sharpe ratio for a retirement portfolio?
- A Sharpe ratio above 0.5 is considered acceptable, above 0.7 is good, and above 1.0 is excellent. A diversified 60/40 stock/bond portfolio has historically achieved a Sharpe ratio around 0.5-0.7. Values above 1.0 are rare for passive portfolios and should be viewed with skepticism over short measurement periods.
- Does a higher Sharpe ratio mean a better retirement plan?
- Not necessarily. The Sharpe ratio measures risk-adjusted return but doesn't account for the magnitude of returns needed to fund retirement. A cash portfolio has low volatility and a decent Sharpe ratio but won't grow enough to sustain 30 years of withdrawals. For retirement planning, you need both an adequate return level and good risk efficiency.