Sharpe ratio explained: how to measure risk-adjusted return
The Sharpe ratio measures return per unit of risk: an investment's return above the risk-free rate, divided by the volatility of its returns.
What the Sharpe ratio tells you
Two funds both returned 10% last year. One got there smoothly; the other lurched up and down by 30%. The Sharpe ratio, introduced by the economist William F. Sharpe in 1966, puts a number on that difference: it measures how much return an investment earned above a risk-free alternative for each unit of volatility it took on.
The higher the ratio, the better the risk-adjusted return. That makes it one of the most widely used yardsticks for comparing funds, strategies and portfolios.
How it is calculated
Use the same period and frequency for every input — usually annual figures:
Sharpe ratio = (Rp − Rf) ÷ σp Rp = portfolio return · Rf = risk-free rate · σp = volatility Annual Sharpe ≈ daily Sharpe × √252
The risk-free rate is usually a short-term government bill yield in the currency of the investment. If you compute the ratio from daily returns, multiply by the square root of the number of periods in a year to annualise it.
A worked example
Portfolio A returned 12% with 16% volatility; portfolio B returned 10% with 8% volatility; the risk-free rate was 4%. A's Sharpe ratio is (12 − 4) ÷ 16 = 0.50; B's is (10 − 4) ÷ 8 = 0.75. B earned less in absolute terms but was paid more for each unit of risk. In principle, holding more of B until it matched A's risk would have offered a higher expected return.
For context, broad stock markets have historically delivered Sharpe ratios well below 1 over long periods, so a strategy claiming a sustained ratio far above 1 deserves healthy scepticism.
Limitations and common mistakes
Sharpe treats all volatility as bad, including sudden gains, and assumes returns are roughly normally distributed. Strategies that earn small, steady profits while carrying a rare risk of large losses — selling insurance-like options, for example — can show excellent Sharpe ratios right up until they blow up. The Sortino ratio, which only counts downside volatility, and maximum drawdown help fill those gaps.
The result also depends on the period, the data frequency and the risk-free rate chosen. Compare ratios only when they are calculated the same way, over the same window and in the same currency.
Frequently asked questions
What is a good Sharpe ratio?
As a rough guide, higher is better, and a ratio above 1 sustained over many years is considered strong. Broad stock indices have typically been below that over long periods. Always compare ratios computed over the same period and with the same method.
Can the Sharpe ratio be negative?
Yes — whenever the investment returned less than the risk-free rate. A negative Sharpe ratio means a risk-free asset would have done better over that period.
What is the difference between the Sharpe and Sortino ratios?
The Sharpe ratio divides excess return by total volatility. The Sortino ratio divides it only by downside volatility, so it doesn't penalise large upward moves.