Sharpe ratio

The Sharpe ratio measures how much return an investment or portfolio delivers for each unit of risk it takes on, where risk is defined as the volatility of its returns. A higher Sharpe ratio means more return was earned per unit of risk; a fund that returns less but does so far more smoothly can have a higher Sharpe ratio than one with bigger gains and equally bigger swings.

It is calculated as (Rp - Rf) / σp, where Rp is the portfolio's average return, Rf is the risk-free rate over the same period, and σp is the standard deviation of the portfolio's returns. Unlike the sortino ratio, which only penalizes downside volatility, the Sharpe ratio treats upside and downside swings identically, so a fund with occasional large gains is penalized the same as one with equally large losses.

Analysts use the Sharpe ratio to compare strategies or managers on a risk-adjusted basis rather than by raw return alone, and it is a standard input to portfolio construction and manager selection, often reported alongside alpha and beta. The main pitfalls: it assumes returns are roughly normally distributed, so it can understate risk for strategies prone to rare, large losses; it is sensitive to the sampling period and the chosen risk-free-rate benchmark; and ratios annualized from short windows of data can be unstable and misleading for comparison.