Sharpe Ratio
The Sharpe ratio measures risk-adjusted return: how much excess return an investment earned above a risk-free rate for each unit of volatility it carried.
Developed by Nobel laureate William F. Sharpe, the ratio is calculated as (portfolio return minus risk-free rate) divided by the standard deviation of the portfolio's returns. Treasury bill yields are commonly used as the risk-free rate.
Example: Fund A returns 10% with a standard deviation of 15%, and Fund B returns 8% with a standard deviation of 8%. With a risk-free rate of 2%, Fund A's Sharpe ratio is (10 - 2) / 15 = 0.53, while Fund B's is (8 - 2) / 8 = 0.75. Fund B delivered more return per unit of risk, even though its total return was lower.
A higher Sharpe ratio is generally better when comparing investments over the same period. As a rough guide, broad stock indexes have historically had long-run ratios well below 1, so sustained values above 1 are considered strong.
The ratio has weaknesses. It treats upside and downside volatility alike, assumes returns are roughly normally distributed, and can be flattered by strategies with hidden tail risks. The Sortino ratio is a variation that counts only downside volatility.