Sharpe Ratio

Sharpe Ratio = (Rp - Rf) / σp, where Rp = portfolio return, Rf = risk-free rate (typically the yield on short-term Treasury bonds), and σp = standard deviation of portfolio returns. The numerator (Rp - Rf) is called the excess return — the return above what you could earn risk-free.

Interpreting Sharpe ratios: Below 0 = poor (worse than risk-free). 0-1.0 = adequate. 1.0-2.0 = good. 2.0-3.0 = very good. Above 3.0 = excellent (and rare for sustained periods). The S&P 500's long-term Sharpe ratio has averaged approximately 0.4-0.5.

The Sharpe ratio assumes returns are normally distributed, which is not always the case. Strategies with asymmetric return profiles (like options strategies) or fat tail risk may have artificially high Sharpe ratios. The Sortino ratio addresses this by only penalizing downside deviation.

The Sharpe ratio is the gold standard for performance evaluation in professional investing. When allocating among multiple investment options, the rational choice is the option with the highest Sharpe ratio (assuming you can adjust leverage to target your desired return level). This insight is fundamental to modern portfolio theory.

For individual investors, the Sharpe ratio helps cut through marketing claims. A fund advertising 20% returns sounds impressive, but if it took enormous risk to achieve that return (low Sharpe ratio), it may be a poor choice compared to a simpler strategy with lower returns but a higher Sharpe ratio.