What It Measures
The Sharpe ratio, devised in 1966 by economist William F. Sharpe, measures the ratio of return from a portfolio to volatility. It is used to compare and select investment options, and identify which portfolio offers the most riskefficient investment.
Why It Is Important
The Sharpe ratio provides a simple way compare two assets with the same expected return—showing which will give the greatest return given an equal level of risk. The key advantage of the Sharpe ratio is that it can be easily calculated without needing any additional data regarding the asset’s profitability.
How It Works in Practice
The Sharpe ratio is calculated by subtracting the riskfree rate from the return of the portfolio, then dividing by the standard deviation of the portfolio. To use the Sharpe ratio, apply the following formula:
Sharpe ratio = (Expected rate of return – Riskfree rate) ÷ Standard deviation of the portfolio
The higher the Sharpe ratio, the better the return for each unit of risk. How does this work in practice?
Imagine that portfolio A generates a return of 15%, while portfolio B generates a return of just 12%. It would seem at first glance that portfolio A has performed better. However, if portfolio A was much riskier then it may be the case that B has a better riskadjusted rate of return.
If we imagine the riskfree rate in this scenario is 5% and the portfolios have standard deviations of 8% and 5% respectively, then we can see that portfolio A would have a Sharpe ratio of 1.25, while portfolio B would have a Sharpe ratio of 1.4. This suggests that, adjusted for risk, portfolio B presents the better investment.
Tricks of the Trade

When using the Sharpe ratio, a score of 1 or better is considered good. A ratio above 2 is considered very good, and 3 would be considered excellent.

Using the Sharpe ratio doesn’t always provide an accurate analysis of return on risk or volatility. This is because portfolio standard deviation can reflect upside or downside returns—and the ratio does not differentiate between these outcomes. Some analysts argue that using standard deviation to measure volatility is not strictly effective, since standard deviation is not a measure of volatility. Instead, standard deviation is really a rough proxy for concepts such as “risk.”

When using the Sharpe ratio, it is wise to adjust the ratio for portfolio analysis. If you are comparing two potential investments for portfolios, then the ratio may not be accurate if one investment is highly correlated with other investments in the portfolio. The solution is therefore to use different Sharpe ratios for different portfolios.

The Sharpe ratio is unusual in that it can be applied to both exante (expected) returns and exposte (historical) returns.