Definition
Developed by Nobel laureate William F. Sharpe in 1966, the Sharpe ratio quantifies how much return an investment generates per unit of total risk taken. It rewards strategies that produce steady returns and penalizes those with high volatility, even if raw returns look attractive. In practice, Sharpe ratios are compared across strategies or funds with a similar mandate. A Sharpe of 1.0 is considered acceptable, 2.0 is very good, and 3.0+ is excellent. Ratios are highly sensitive to the measurement period and the choice of risk-free rate. The Sortino ratio is a related metric that considers only downside volatility, arguing upside volatility should not be penalized.
Sharpe = (Rp − Rf) / σp
Rp = portfolio return, Rf = risk-free rate (typically 3-month T-bill), σp = standard deviation of portfolio returns
Example
A portfolio returns 12% annually with a standard deviation of 10%, when T-bills yield 4%. Sharpe = (12 − 4) / 10 = 0.80. A second portfolio returns 15% with a standard deviation of 20%: (15 − 4) / 20 = 0.55. Despite the second's higher raw return, the first is more efficient risk-adjusted.
Frequently Asked Questions
What is considered a good Sharpe ratio?
Above 1.0 is acceptable; above 2.0 is strong; above 3.0 is exceptional and rare over long periods. Very high short-term Sharpes often shrink when the measurement window widens.
Can Sharpe ratio be negative?
Yes, when portfolio returns fall below the risk-free rate. A negative Sharpe means you would have been better off holding cash or T-bills.
What's the difference between Sharpe and Sortino ratio?
Sharpe uses total standard deviation. Sortino uses only downside deviation, treating upside volatility as a feature rather than a risk.