Sharpe ratio

The Sharpe ratio, devised by the economist William F. Sharpe, is the portfolio’s return minus the risk-free rate, divided by the standard deviation of the portfolio’s returns (strictly, of its returns in excess of the risk-free rate). The numerator is the reward for bearing risk; the denominator is the amount of risk, measured as volatility. A higher ratio means more return per unit of risk. It is usually calculated from monthly or annual data and expressed on an annual basis, which allows portfolios with very different risk levels to be compared on one scale.

The Sharpe ratio is useful for comparing funds or strategies over the same period, but it has blind spots. Because it uses standard deviation, it penalises upside surprises as much as losses, and it can flatter strategies that produce smooth returns most of the time but occasionally suffer large losses, or that hold illiquid assets whose prices are rarely updated. It is also sensitive to the period chosen. A high historical Sharpe ratio describes the past; it is not a promise.