Sharpe Ratio
In short
Return per unit of risk — the gold standard risk-adjusted performance metric
Sharpe ratio measures how much return you get for every unit of risk you take. A Sharpe of 1.0 means for every 1% of risk, you earn 1% return above the risk-free rate. Higher is better.
Sharpe ratio = (Portfolio Return - Risk-Free Rate) ÷ Portfolio Standard Deviation. It penalizes both upside and downside volatility. A Sharpe above 1.0 is good; above 2.0 is excellent. Hedge funds target 1.5+.
Formula
Sharpe = (Rp - Rf) ÷ σpThresholds
- <0
- Worse than risk-free — poor allocation
- 0-0.5
- Below average
- 0.5-1
- Acceptable
- 1-2
- Good risk-adjusted returns
- >2
- Excellent
Related concepts
- Sortino Ratio — Sharpe ratio penalizes all volatility, even upside gains. Sortino only penalizes bad volatility (downside). A fund that has big gains but small losses looks better on Sortino than Sharpe.
- Calmar Ratio — Calmar asks how much return you earned per dollar of maximum pain. If a portfolio returned 15% annually over the period measured but suffered a 30% drop from peak to trough at its worst point, the Calmar ratio is 0.5 — half a percent of return for every percent of that worst loss.
- Maximum Drawdown — If your portfolio hit $10,000 then fell to $6,000 before recovering, the max drawdown is 40%. It measures the worst experience a real investor would have endured.
- Alpha — Alpha is the extra return a fund earns above what you'd expect given its risk. If the market returns 10% and your fund returns 13% with the same risk, alpha is 3%. Positive alpha = the manager adds value.