What Is the Sharpe Ratio?
The Sharpe ratio measures return per unit of risk: the return above a safe rate, divided by volatility. How to calculate it, how to compare investments with it, and what it misses.
In one sentence
Sharpe ratio. An investment's return above a risk-free rate, divided by the standard deviation of that excess return. It measures return earned for each unit of risk.
How it works
Sharpe ratio = (Return − Risk-free rate) ÷ Standard deviation of returns
The numerator is the extra return earned for taking risk, compared with a safe investment such as Treasury bills. The denominator is how much the returns swung around. The higher the ratio, the more return each unit of risk has paid.
| Fund | Yearly return | Standard deviation | Sharpe ratio |
|---|---|---|---|
| A | 9% | 15% | (9 − 4) ÷ 15 = 0.33 |
| B | 7% | 8% | (7 − 4) ÷ 8 = 0.38 |
A returned more, but B earned more for each unit of risk. Which is better for you depends on how much risk you want to take in total.
What it misses
Standard deviation treats a surprise gain the same as a surprise loss, and it doesn't capture rare, severe losses well. That's why investors also look at the Sortino ratio, which counts only downside swings, and at maximum drawdown, the worst peak-to-trough fall. Like any measure built from past returns, a Sharpe ratio describes what happened, not what will.
Learn it properly
- Sharpe, Sortino, and Maximum DrawdownPortfolio Theory and Risk (depth track) · Free