What Is Sharpe Ratio?
The Sharpe ratio measures risk-adjusted return by comparing excess return over the risk-free rate to the volatility (standard deviation) of returns.
Quick Answer
The Sharpe ratio measures risk-adjusted return by comparing excess return over the risk-free rate to the volatility (standard deviation) of returns.
What Does Sharpe Ratio Measure?
Developed by William F. Sharpe, the Sharpe ratio is one of the most widely used metrics to evaluate the risk-adjusted performance of a portfolio or trading strategy. It answers: how much excess return are you getting per unit of risk? A higher Sharpe ratio indicates better risk-adjusted performance. The ratio uses standard deviation of returns as the measure of risk, so it penalizes both upside and downside volatility equally.
Sharpe Ratio = (Rp - Rf) / σp where Rp = portfolio return, Rf = risk-free rate, σp = standard deviation of portfolio excess returnsTypical range: 0.5–2.0 (annualized); negative to 3+ possible
How to Interpret Sharpe Ratio
- 1Sharpe > 1.0 is generally considered good; > 2.0 is very good
- 2Sharpe < 0 means the strategy underperformed the risk-free rate
- 3Compare Sharpe across strategies with similar timeframes and asset classes
- 4Annualized Sharpe is common: multiply by √(periods per year) for consistency
How to Use Sharpe Ratio in Backtesting & Portfolio Analysis
Common Mistakes to Avoid
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