What Is Sharpe Ratio?
The Sharpe Ratio, developed by William F. Sharpe, measures excess return per unit of risk. It's calculated as: (return − risk-free rate) ÷ standard deviation of returns.
A higher Sharpe means better risk-adjusted performance. Rough benchmarks: Sharpe below 1 is mediocre; 1-2 is good; 2-3 is excellent; above 3 is exceptional (and rare). Buy-and-hold of major indices typically generates Sharpe ratios around 0.5-0.8 long-term.
The Sharpe Ratio is widely used but has known limitations. It penalises upside volatility the same as downside (Sortino addresses this), assumes returns are normally distributed (they aren't), and can be gamed by smoothing techniques in monthly reporting. Despite these issues, it remains the standard risk-adjusted measure because nothing simpler has replaced it.
Related terms
- Drawdown — The peak-to-trough decline in account equity during a losing streak.
- Expectancy — The average profit or loss per trade, given win rate and average win/loss size.
- Volatility — A statistical measure of how much an asset's price varies over a period.