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The Sharpe Ratio tells you how much return you’re getting for each unit of risk you’re taking. It’s the most widely used measure of risk-adjusted performance in the investment industry.

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Beginner

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What It Means

The Sharpe Ratio measures “bang for your buck” in terms of risk. Higher is better - you’re getting more return for each unit of volatility you endure.

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Portfolio Example

*Assuming 2% risk-free rate Even though Portfolio B has higher returns, Portfolio A is better on a risk-adjusted basis. You’re getting more reward per unit of risk.

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Why It Matters

It helps you compare different investments fairly. A 20% return with 30% volatility isn’t necessarily better than a 12% return with 8% volatility. The Sharpe Ratio reveals which investment is truly more efficient.

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Advanced

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Mathematical Definition

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Historical Context

Developed by William Sharpe (1966), originally called the “reward-to-variability ratio.” It became the industry standard for risk-adjusted performance measurement. Sharpe received the 1990 Nobel Prize partly for this contribution.

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Interpretation Benchmarks

For long-only equity strategies (annualized): Strategy-Specific Benchmarks:
  • Long-only equity: SR 0.5-1.0 typical, >1.5 excellent
  • Long/short equity: SR 1.0-2.0 good, >2.5 excellent
  • Market-neutral: SR >2.0 achievable but rare over multi-year periods

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What Makes It Useful

  • Universal Comparability: Can compare across any asset classes or strategies
  • Intuitive Interpretation: Simple ratio that captures risk-return tradeoff
  • Portfolio Optimization: Maximizing Sharpe Ratio leads to optimal risk-adjusted portfolios
  • Performance Evaluation: Standard metric for evaluating fund managers and strategies

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Data Requirements

Statistical Confidence:
  • Sharpe = 0.5 needs ~4 years to be statistically different from zero
  • Sharpe = 1.0 needs ~2 years to be statistically significant
Short-period (less than 2 years) Sharpe Ratios are essentially noise. Bull vs. bear markets dramatically affect estimates.

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Limitations

  • Assumes Normal Distribution: Real return distributions have fat tails and skewness; Sharpe Ratio doesn’t capture this
  • Symmetric Risk Treatment: Treats upside and downside volatility equally, but investors care more about downside
  • Time Period Sensitive: Can vary significantly based on measurement period
  • Gaming Potential: Can be artificially inflated through return smoothing or option writing strategies

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Alternatives

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Related Terms

Standard Deviation

The denominator in Sharpe Ratio

Information Ratio

Active management version

Treynor Ratio

Uses beta instead of volatility