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Sharpe Ratio

Risk-adjusted return metric measuring excess return earned per unit of total volatility.

Investment Management

FAQs

What is a good Sharpe Ratio?

Generally, a Sharpe Ratio above 1.0 is acceptable, above 2.0 is considered good, and above 3.0 is excellent. However, thresholds vary by asset class and strategy—what's strong for an equity fund may be modest for a fixed-income portfolio.

How does the Sharpe Ratio differ from raw return?

Raw return ignores risk. A fund returning 20% with high volatility may be less attractive than one returning 12% with low volatility. The Sharpe Ratio normalizes returns by risk, allowing fair comparison between strategies with different risk profiles.

What are the limitations of the Sharpe Ratio?

The Sharpe Ratio treats upside and downside volatility equally, which can disadvantage strategies with positive skew. It also assumes normally distributed returns and can be gamed by strategies that generate steady returns but carry hidden tail risks.

Related Terms

Sortino Ratio

Risk-adjusted return metric using only downside deviation rather than total standard deviation.

Alpha

Excess return of an investment relative to a benchmark index after adjusting for risk.

Beta

Measure of an investment's volatility relative to the overall market or benchmark index.

Value at Risk

Statistical estimate of maximum potential loss over a time period at a given confidence level.

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The Sharpe Ratio, developed by Nobel laureate William F. Sharpe, measures the risk-adjusted performance of an investment by calculating the excess return (return above the risk-free rate) per unit of standard deviation (total volatility). The formula is: Sharpe Ratio = (Portfolio Return − Risk-Free Rate) / Standard Deviation of Portfolio Returns. A higher Sharpe Ratio indicates better risk-adjusted performance—the investor is earning more return per unit of risk taken. A Sharpe Ratio above 1.0 is generally considered acceptable, above 2.0 is good, and above 3.0 is excellent, though context and investment strategy matter. A negative Sharpe Ratio means the investment is underperforming even a risk-free instrument, making it unattractive. The Sharpe Ratio is widely used to compare portfolios, mutual funds, and hedge funds on a level playing field, regardless of absolute return levels. Its main limitation is that it uses standard deviation as a risk proxy, which penalizes both upside and downside volatility equally. Strategies with asymmetric return distributions—like options writing—can appear to have high Sharpe Ratios while carrying substantial tail risk not captured by standard deviation. The Sharpe Ratio also depends heavily on the choice of risk-free rate and the measurement period. To address these limitations, variants such as the Sortino Ratio (which only penalizes downside volatility) and the Calmar Ratio (which uses maximum drawdown) have been developed. Despite its limitations, the Sharpe Ratio remains the most commonly cited risk-adjusted performance metric in the investment industry.