How it works
Take the investment's return, subtract the risk-free rate to get the excess return, and divide by the standard deviation of returns. Two funds with the same return can have different Sharpe ratios if one swung far more than the other.
The Sharpe ratio is useful for comparing investments or funds on a risk-adjusted basis. It assumes returns are roughly symmetrical, so it can understate the risk of strategies that have rare but large losses.
Sharpe ratio = (Return − Risk-free rate) ÷ Standard deviation of returns
A simple example
How it is used
- Comparing funds and portfolios on a risk-adjusted basis.
- Judging whether extra return justified extra risk.
- Reviewing a manager's track record.
Common mistakes
- Comparing Sharpe ratios measured over different periods.
- Ignoring that returns may not be symmetrical.
- Using too short a track record.
- Judging a strategy with rare large losses by this ratio alone.
Questions
What is a good Sharpe ratio?
As a rough guide, above 1.0 is often considered good and above 2.0 very good, but it varies by strategy and period. Compare like with like.
What is the difference between the Sharpe ratio and alpha?
The Sharpe ratio compares excess return with total volatility. Alpha compares return with what the investment's beta would predict.
Keep learning
- What is alpha in finance?
- What is beta in finance?
- What is CAPM and the cost of equity?
- Damodaran: historical returns on stocks, bonds and real estate
- Glossary: Sharpe ratio
- Glossary: Volatility (standard deviation)
- Glossary: Alpha
- Glossary: Risk-free rate