Sharpe Ratio and Standard Deviation: Mutual Fund Risk Numbers Explained

Two funds can show the same return over five years, but one got there smoothly and the other went through sharp falls. Most people would rather hold the smoother one, because they are less likely to panic and sell in the middle.

Risk numbers help you see that difference, which a headline return hides. Our page on risk and volatility explains the idea behind them.

Standard deviation measures how widely a fund returns have moved around their own average over a period.

A low number means returns stayed fairly close to the average, so the ride was calmer. A high number means returns swung widely above and below, so the ride was bumpier.

It says nothing about whether the swings were up or down. It only measures how big they were.

That is why it is usually read together with the fund return. A high return with a very high standard deviation means a strong result came with a rough ride, which not everyone can sit through.

The Sharpe ratio asks: for all the ups and downs this fund put you through, how much extra return did you get?

It takes the fund return, subtracts what you could have earned from a very low-risk alternative, and divides by the standard deviation. A higher Sharpe ratio means more reward for each unit of bumpiness.

So if two funds in the same category have similar returns, the one with the higher Sharpe ratio achieved it with a smoother ride.

Beta compares a fund movement with its benchmark. A beta of about one means the fund tends to move roughly in line with the benchmark.

Above one means it has tended to swing more than the benchmark, rising more in good times and falling more in bad. Below one means it has tended to swing less. Our page on the benchmark explains what a fund is compared against.

Most fund houses publish them on the monthly fact sheet, usually in a small section called risk measures or ratios, along with the period they cover. Our page on the fact sheet shows where to look.

Many comparison websites also show them. Always check which period the numbers are calculated over, because a different period gives different numbers.

A small cap fund will almost always have a higher standard deviation than a liquid fund. That does not make the small cap fund bad or the liquid fund good. They are built for different jobs.

Compare risk numbers only between funds in the same category, over the same period. Comparing a mid cap fund with a debt fund on standard deviation tells you nothing useful.

Also make sure both numbers cover the same period. A three-year figure and a five-year figure are not comparable.

Imagine two funds in the same category that both reached the same place over five years.

Fund A went up steadily with small dips. Fund B fell sharply twice and then recovered. Fund A would show a lower standard deviation and a higher Sharpe ratio, because it delivered the same result with less bumpiness.

Many investors in Fund B would have sold during one of those sharp falls and never seen the recovery. That is why these numbers matter in real life, not just on paper.

All these numbers are calculated from past returns. They describe how the fund behaved, not how it will behave.

A fund can have a calm few years and then a very rough one. Markets change, fund managers change, and a short measurement period can be misleading. Use the numbers as one input among several, not as a forecast.

A practical way to use them in your yearly review:

• Shortlist funds in the category you need.
• Compare their returns against the benchmark over several years.
• Then use the Sharpe ratio and standard deviation as a tie-breaker between similar funds.
• Check that the beta fits your comfort with swings.

Our page on how to review your portfolio puts this into a full yearly routine.

Sortino ratio is similar to Sharpe, but it only counts downward swings as risk, since most people do not mind upward ones.

Alpha tries to show how much extra return a fund manager added beyond what the benchmark delivered.

Portfolio turnover shows how often the fund buys and sells, which can hint at costs and style.

They are all useful for comparison within a category, and all carry the same warning: they describe the past.

They cannot tell you whether a fund suits your goal date. They cannot tell you about the fund manager style, costs, or how concentrated the portfolio is. And they cannot tell you how you personally will feel when a fund falls.

The most important risk question is still simple: is money you need soon sitting in something that can fall sharply? Our page on asset allocation covers that, and it matters far more than any ratio.

• Standard deviation: how bumpy the ride has been.
• Sharpe ratio: how much return you got for the bumps.
• Beta: how much the fund swings compared with its benchmark.
• Compare only within the same category and period.

We are distributors rather than investment advisers and we recommend no schemes. If you want help reading the risk numbers on your fact sheets, get in touch.