The Sharpe Ratio is the most widely used metric for evaluating investment performance. It answers a fundamental question: how much return do you get per unit of risk? Two funds with different returns and risks can be compared fairly only on a risk-adjusted basis.
The Formula and What It Means
The Sharpe Ratio formula is: (Return - Risk-Free Rate) / Standard Deviation. The numerator is excess return above the risk-free rate. The denominator is volatility (risk). A higher Sharpe Ratio means better returns relative to risk taken.
A Sharpe Ratio of 1.0 means earning 1% excess return per 1% of volatility. A Sharpe Ratio of 2.0 is exceptional. Most active managers achieve Sharpe Ratios below 0.5. The S&P 500 historically achieves around 0.4-0.6.
Why Risk-Adjusted Matters
A strategy returning 20% with 40% volatility is riskier than one returning 10% with 10% volatility. Comparing raw returns is meaningless. The Sharpe Ratio puts them on equal footing: the first has 0.5 Sharpe, the second has 1.0 Sharpe (assuming 0% risk-free rate).
This is critical for investors. You want the best return per unit of risk accepted. The Sharpe Ratio quantifies exactly that trade-off, enabling rational comparison across any strategy.
Limitations of the Sharpe Ratio
The Sharpe Ratio assumes returns are normally distributed. In reality, financial returns have fat tails. A strategy with occasional catastrophic losses might have the same volatility as a smooth-returning strategy, yet the Sharpe Ratio treats them identically.
The risk-free rate assumption matters. Using current 4% rates vs. historical 1% rates changes comparisons significantly. The denominator (volatility) also assumes volatility is the right risk measure, which isn't always true for non-normal distributions.
Alternatives and Complements
The Sortino Ratio fixes one Sharpe limitation by counting only downside volatility. Calmar Ratio uses maximum drawdown instead of volatility. Information Ratio compares to a benchmark. Each has merits depending on the question being asked.
Use the Sharpe Ratio as your primary tool, but supplement it with others. A high Sharpe Ratio with large tail risks is less attractive than a slightly lower Sharpe Ratio with controlled tail risk.
Educational content only. Not investment advice.