Sharpe ratio

The Sharpe ratio, developed by Nobel laureate William Sharpe, answers one question: was the portfolio’s return worth the risk taken? It compares the return in excess of the risk-free rate with volatility, the standard deviation of returns.

Example: a portfolio earned 10% in a year, the risk-free rate (e.g. the yield on short-term government bonds) was 5%, and annual volatility was 15%. The ratio is (10% − 5%) ÷ 15% ≈ 0.33. Another portfolio that earned 9% with 8% volatility has a ratio of 0.5: it earned less, but got more for each unit of risk.

Limitations of the Sharpe ratio

• It treats rises and falls as risk in the same way. The Sortino ratio is a variant that penalizes only declines.
• It assumes returns are roughly normally distributed, so it underestimates rare, sudden crashes.
• The result depends heavily on the period, the data frequency (daily, monthly) and the risk-free rate used. Only compare ratios calculated the same way.
• A high ratio over a short period is easy to overrate: a few calm months say little about risk in a crisis.
• It measures the portfolio’s risk in isolation, without telling you how it fits with the rest of your wealth.

Read the Sharpe ratio together with maximum drawdown and a benchmark: together they show how much you earned, how much it hurt along the way, and whether a simple index fund would have done better.