Sharpe Ratio

A risk-adjusted return measure — the average return earned above the risk-free rate per unit of volatility, used to compare investments with different risk levels.

The Sharpe ratio is calculated as (Portfolio Return − Risk-Free Rate) ÷ Standard Deviation of Portfolio Returns. A Sharpe ratio of 1.0 means the portfolio earned 1% of excess return for every 1% of annual volatility. Higher is better — a portfolio with a Sharpe of 2.0 is generating twice the risk-adjusted return of one with a Sharpe of 1.0, making it more efficient per unit of risk taken.

Sharpe ratios are most useful for comparing strategies or portfolios with different volatility profiles. Two funds might both return 12% annually, but if one achieves it with 10% volatility (Sharpe ~1.0) and another with 20% volatility (Sharpe ~0.5), the first fund is delivering far superior risk-adjusted performance. The S&P 500 has historically produced a Sharpe ratio of approximately 0.4–0.6 over long periods.

The Sharpe ratio has limitations: it assumes returns are normally distributed (they aren't — fat tails exist), it uses volatility as a proxy for all risk (missing tail risk and illiquidity), and it can be inflated by strategies with high average returns but rare, devastating losses (like selling far out-of-the-money options). The Sortino ratio modifies Sharpe by penalizing only downside volatility, which many investors find more intuitive.

This definition is for informational and educational purposes only. Nothing on Finance Compass constitutes financial, investment, or trading advice. Always conduct your own research and consult a qualified professional before making financial decisions.