The Sharpe ratio was developed by Nobel laureate William F. Sharpe and is used to help investors understand the return of an investment compared to its risk. it is used when assessing the performance of investment management products and professionals. It is defined as the difference between the returns of the investment and the risk-free return, divided by the standard deviation of the investment, i.e. it's volatility. Conceptually, what this provides is a measurement of the investment’s outperformance per unit of its volatility.
The Sharpe ratio characterizes how well the return of an asset compensates the investor for the risk taken. When comparing two assets versus a common benchmark, the one with a higher Sharpe ratio provides better return for the same risk (or, equivalently, the same return for lower risk).
Namely, Sharpe ratio considers the ratio of a given stock's excess return to its corresponding standard deviation. Excess return is considered as a performance indicator of stock fund.
Sharpe Ratio = (Rp - Rf) / σp
where,
Rp = return of investment
Rf = risk-free rate
σp = standard deviation of the investment (volatility)
In the Notebook, a benchmark is given to calculate Sharpe Ratio of the two stocks of giant tech Facebook & Amazon as portfolio. Furthermore, performance of the 500 largest stocks in the US in the S&P 500 will be used as benchmark of risk-free rate.