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.
Beginner
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.
Portfolio Example
| Portfolio | Return | Volatility | Sharpe Ratio* |
|---|
| Portfolio A | 12% | 8% | 1.25 |
| Portfolio B | 15% | 15% | 0.87 |
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.
Advanced
Mathematical Definition
Sharpe Ratio = (Rp - Rf) / σp
Where:
- Rp = Portfolio return
- Rf = Risk-free rate (typically 3-month T-bills)
- σp = Portfolio standard deviation (total volatility)
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.
Interpretation Benchmarks
For long-only equity strategies (annualized):
| Sharpe Ratio | Interpretation |
|---|
| < 0 | Portfolio underperforming risk-free rate |
| 0 to 0.5 | Below average risk-adjusted returns |
| 0.5 to 1.0 | Good risk-adjusted performance |
| 1.0 to 1.5 | Very good risk-adjusted performance |
| > 1.5 | Excellent (rare over multi-year periods) |
- 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
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
Data Requirements
| Requirement | Duration | Notes |
|---|
| Minimum | 36 months (3 years) | Basic Sharpe Ratio estimate |
| Preferred | 60-120 months (5-10 years) | Stable, meaningful comparisons |
- 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.
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
Alternatives
| Alternative | Use Case |
|---|
| Sortino Ratio | Uses downside deviation instead of total volatility, focusing on harmful volatility |
| Calmar Ratio | Return over maximum drawdown, captures tail risk better |
| Information Ratio | For active strategies, measures excess return per unit of active risk |
| Omega Ratio | Probability-weighted ratio of gains vs. losses above/below threshold |
