investing

Sharpe ratio

A measure of risk-adjusted return, calculated as the excess return above the risk-free rate divided by standard deviation. Higher means better return per unit of risk.

Example

“The fund with a Sharpe ratio of 1.5 delivered better risk-adjusted returns than the one with a ratio of 0.8.”

Memory Tip

SHARPE ratio = how SHARP (efficient) your returns are per unit of risk taken.

Why It Matters

The Sharpe ratio helps you compare investments fairly by accounting for the risk you take to earn returns. Two investments might have the same return, but one could be much riskier, and this metric reveals which one gives you better compensation for the risk you are taking on.

Common Misconception

Many people think a higher Sharpe ratio always means an investment will perform better in the future. The Sharpe ratio is based on historical data and past volatility, so it does not guarantee future results or predict upcoming performance.

In Practice

Suppose Fund A returned 10 percent annually with 8 percent volatility while Fund B returned 10 percent with 12 percent volatility, and the risk-free rate is 2 percent. Fund A has a Sharpe ratio of 1.0 while Fund B has 0.67, meaning Fund A gave you better return per unit of risk even though both had identical returns.

Etymology

Named after Nobel laureate William F. Sharpe, who developed it in 1966.

Common Misspellings

sharpe rationsharp ratiosharpe racio

Related Terms

risk-adjusted return alpha volatility

More in investing

Other investing terms you should know

appreciationAn increase in the value of an asset over time.…bondA fixed-income investment where an investor loans money to a…diversificationA risk management strategy that mixes a wide variety of inve…dividendA payment made by a corporation to its shareholders, usually…expense ratioThe annual fee that mutual funds or ETFs charge investors, e…fixed incomeInvestments that provide a regular, predetermined return, su…