Risk-adjusted return: (portfolio return − risk-free rate) ÷ volatility. Higher is better. A long-run Sharpe of 0.5 – 1.0 is solid; above 1.0 is excellent.
The Sharpe ratio measures risk-adjusted return — how much excess return an investment generates per unit of volatility it takes on.
Formula: (portfolio return − risk-free rate) ÷ standard deviation of portfolio returns.
Higher is better. A Sharpe of 1.0 means the portfolio earns one full unit of excess return for each unit of volatility risked.
Below 0.5: poor risk-adjusted return. The portfolio takes too much risk for the excess return delivered.
0.5 – 1.0: solid. Typical for broad-market equity portfolios over long horizons.
1.0 – 2.0: excellent. Indicates either skill, leverage applied to a low-volatility strategy, or a lucky time window.
Above 2.0: usually a short measurement window, or hidden tail risk that hasn't shown up yet. Long-run sustainable Sharpe above 2 is extremely rare.
Assumes returns are normally distributed. Real returns have fat tails — extreme moves happen more often than the bell curve predicts. Sharpe understates risk in fat-tailed regimes.
Penalises upside volatility identically to downside. Sortino ratio (which only penalises downside volatility) is a refinement.
Risk-free rate choice matters: 1-year T-bill or 10-year government bond? Different choices yield different Sharpes. Disclose the assumption.
Window-dependent: a 5-year Sharpe can look great in a bull market and terrible after a bear market. Look at 10+ year windows for reliability.
Comparing funds: Fund A returns 10% with 20% volatility; Fund B returns 8% with 10% volatility. At a 2% risk-free rate, A's Sharpe = 0.40, B's = 0.60. B is the better risk-adjusted choice despite lower headline return.
Portfolio optimisation: classic mean-variance optimisation maximises Sharpe across a portfolio. Modern Portfolio Theory's core insight.
Don't single-metric: combine Sharpe with maximum drawdown, time-to-recovery, and worst-year return for a fuller picture. A high Sharpe with a 60% drawdown is psychologically unholdable for most investors.
A risk-adjusted return measure: (portfolio return − risk-free rate) ÷ portfolio volatility. Higher is better. Measures how much excess return you're earning per unit of risk taken. Useful for comparing investments with different volatility profiles.
Below 0.5: poor. 0.5 – 1.0: solid (typical broad-equity portfolio long-term). 1.0 – 2.0: excellent (skill, leverage, or favourable period). Above 2.0: usually a short measurement window or hidden tail risk. Long-run sustainable Sharpe above 2 is extremely rare.
Treats upside and downside volatility identically. A fund with big upside swings has the same Sharpe as one with big downside swings — but investors care far more about losses. Sortino ratio (which only penalises downside volatility) is a useful refinement.
Annualised return minus risk-free rate (use 10-year SGS or T-bill yield), divided by annualised standard deviation of monthly returns. Need at least 3 – 5 years of monthly data for meaningful Sharpe. Most robo-advisors and fund platforms publish Sharpe for their portfolios.