To understand what a portfolio is please read my article here.
What is Sharpe ratio? It is a measure that adjust returns for risk. It enables you in a quantitative way to chose between two or more stocks.
Why and when will you need to use it? The simple answer to this is, if you are building a portfolio and are looking at instruments which seem to have the same performance, for example they rise 2% each month. You only have money to select three out of twenty such stocks what do you do?
Well one of the measures you can use is the Sharpe ratio developed by William Sharpe. This takes into account the volatility and risk free interest.
Historically, risk-free rate used for the calculation, were for example LIBOR and 3 month T-bill (90days). In more recent years this is set to 0%.
The Sharpe ratio can be viewed as return vs risk ratio i.e. how much risk was taken to obtain the return.
- A high Sharpe ratio with a high portfolio return shows return to risk ratio was low
- A Low Sharpe ratio with a high portfolio return shows return to risk ration was high. So a lot of risk was taken.