The Sharpe Ratio, developed by Nobel laureate William Sharpe, is one of the most widely used metrics for evaluating investment performance. It measures how much excess return you receive for the extra volatility you endure for holding a riskier asset.
Formula
Sharpe Ratio = (Rp - Rf) / σp
Where:
- Rp = Return of the portfolio
- Rf = Risk-free rate (typically the government bond yield)
- σp = Standard deviation of portfolio returns (volatility)
Interpretation
| Sharpe Ratio | Quality |
|---|---|
| < 1.0 | Sub-optimal |
| 1.0 – 1.5 | Good |
| 1.5 – 2.0 | Very good |
| > 2.0 | Excellent |
Limitations
- Assumes returns are normally distributed (ignores fat tails)
- Penalizes upside volatility equally with downside volatility
- Sensitive to the time period and frequency of measurement
- The Sortino Ratio addresses the downside-only limitation