Sharpe Ratio
A measure of risk-adjusted return calculated by subtracting the risk-free rate from the portfolio return and dividing by the standard deviation of returns. Higher values indicate better compensation for the risk taken.
The Sharpe ratio, developed by Nobel laureate William Sharpe, is one of the most widely used metrics for evaluating investment performance on a risk-adjusted basis. It answers a simple but critical question: how much excess return are you receiving for the extra volatility you endure?
How It's Calculated
The formula is: (Portfolio Return − Risk-Free Rate) / Standard Deviation of Portfolio Returns. A Sharpe ratio above 1.0 is generally considered acceptable, above 2.0 is very good, and above 3.0 is excellent. A negative Sharpe ratio means the investment returned less than the risk-free rate.
When comparing two portfolios with similar returns, the one with the higher Sharpe ratio achieved those returns with less risk. This makes it invaluable for backtesting portfolios and selecting among competing strategies. Keep in mind that the Sharpe ratio assumes returns are normally distributed and may understate risk for investments with skewed or fat-tailed return distributions.
For a deeper dive, see our Sharpe ratio explainer.