Sharpe ratio

The Sharpe ratio measures how much excess return a portfolio earns per unit of volatility. It is the most common single-number measure of risk-adjusted return.

Formula

sharpe_ratio = (portfolio_return - risk_free_rate) / portfolio_volatility

Where:

• portfolio_return is the annualized return of the portfolio
• risk_free_rate is the return of a riskless asset, typically the 3-month US Treasury bill
• portfolio_volatility is the annualized standard deviation of returns

How to read it

• > 1.0 — solid risk-adjusted performance
• > 2.0 — strong, often associated with well-constructed portfolios
• > 3.0 — exceptional, frequently a sign that the measurement window is too short to be reliable
• < 1.0 — the portfolio is not adequately compensating for the volatility it carries

What it's good for

The Sharpe ratio lets you compare two portfolios with different risk levels on a common footing. A portfolio that returns 12% with low volatility may have a higher Sharpe than one that returns 18% with much higher volatility — the lower-return portfolio may actually be better at converting risk into return.

Limitations

• Treats upside and downside volatility the same. Big gains hurt the Sharpe just as much as big losses.
• Assumes returns are normally distributed. Real-world returns have fat tails — Sharpe understates the risk in strategies that occasionally blow up.
• Sensitive to the measurement window. A 1-year Sharpe and a 10-year Sharpe can differ dramatically.