What is the Sharpe Ratio?

The Sharpe ratio is one of the most widely used metrics in finance for evaluating the risk-adjusted performance of an investment or portfolio. Named after Nobel laureate William F. Sharpe, it measures how much excess return you receive for the extra volatility you endure holding a riskier asset.

In simple terms, the Sharpe ratio helps answer the question: “Is the return I'm getting worth the risk I'm taking?”

The Sharpe Ratio Formula

The numerator (Rp - Rf) represents the excess return - the return above what you could earn from a risk-free investment like Treasury bills. The denominator (σp) is the standard deviation of the portfolio's returns, which measures volatility or risk.

How to Interpret the Sharpe Ratio

A higher Sharpe ratio indicates better risk-adjusted performance. However, context matters - what's considered “good” varies by asset class and market conditions. Always compare portfolios with similar investment objectives.

Practical Example

Let's say Portfolio A has an annual return of 12% with a standard deviation of 10%, and the risk-free rate is 2%.

Now compare to Portfolio B with 15% return but 20% standard deviation:

Despite Portfolio B having higher absolute returns, Portfolio A has better risk-adjusted returns. For each unit of risk taken, Portfolio A generates more excess return.

Limitations

While powerful, the Sharpe ratio has some limitations:

• Assumes returns are normally distributed (may not hold for all investments)
• Treats upside and downside volatility equally (the Sortino ratio addresses this)
• Can be manipulated through leverage or derivatives
• Historical ratios may not predict future performance