Sharpe Ratio -- Risk-Adjusted Return Explained

The Sharpe ratio, developed by Nobel laureate William Sharpe, divides a portfolio's excess return (above the risk-free rate) by its standard deviation of returns:

Sharpe Ratio = (Portfolio Return - Risk-Free Rate) / Standard Deviation

Interpreting the Sharpe Ratio

• Below 0.5: Poor -- you are taking significant risk for limited reward.
• 0.5 to 1.0: Acceptable -- returns compensate for risk, but not generously.
• 1.0 to 2.0: Good -- meaningful risk-adjusted outperformance.
• Above 2.0: Excellent -- rare outside of specific strategies or favorable periods.

Limitations

The Sharpe ratio treats upside and downside volatility equally. A portfolio that occasionally spikes dramatically upward is penalized as much as one that drops sharply. For this reason, the Sortino ratio -- which only penalizes downside volatility -- is often preferred for asymmetric return profiles.

Sharpe ratios are also time-period dependent. A high Sharpe during a bull market may collapse during a drawdown. Always examine Sharpe across multiple periods.