Sharpe Ratio
The Sharpe ratio measures how much return an investment earns above the risk-free rate for each unit of risk it takes. It is calculated by subtracting the risk-free rate from the portfolio's return and dividing by the portfolio's standard deviation. A higher Sharpe ratio means better risk-adjusted performance; it lets investors compare portfolios with different levels of volatility on a fair basis.
Worked example
A portfolio returns 8% over a year, the risk-free rate is 2%, and the portfolio's standard deviation is 12%. Sharpe ratio = (8% − 2%) ÷ 12% = 6% ÷ 12% = 0.5. For every unit of volatility, the portfolio earned 0.5 units of excess return.
Why it matters
The Sharpe ratio matters because raw returns alone can be misleading: a fund may look impressive only because it took on far more risk. By penalising volatility it reveals how efficiently risk was converted into return. A key pitfall is that it treats upside and downside swings identically, so a fund with sharp but profitable jumps can be unfairly penalised; it is also easily distorted over short or unusual periods.
Frequently asked questions
What is a good Sharpe ratio?
As a rough guide, a ratio above 1 is considered good, above 2 very good, and above 3 excellent, while a ratio below 1 suggests the return did not adequately compensate for the risk taken.
What is the difference between the Sharpe ratio and the Sortino ratio?
The Sharpe ratio divides excess return by total volatility, counting both up and down moves. The Sortino ratio divides only by downside volatility, so it does not penalise positive swings.
Related terms: Volatility, Standard Deviation