Measuring performance
Sharpe ratio
Return above the risk-free rate, divided by volatility — how much return each unit of risk bought.
How it works
The Sharpe ratio is the standard risk-adjusted return measure. It asks whether a higher return was earned by skill or simply by taking more risk.
Roughly, below 0.5 is unremarkable, around 1 is good, and sustained readings well above that are rare enough to warrant asking how they are produced.
Where it misleads people
Sharpe penalises upside volatility identically to downside, and it is easy to inflate with a negatively skewed strategy. Anything that sells insurance shows a superb Sharpe until the event it insured against occurs.
Formula
Sharpe = (portfolio return − risk-free rate) ÷ standard deviation of portfolio returnsWorked example
A portfolio returning 11% with 12% volatility, when cash pays 3%: (11 − 3) ÷ 12 = 0.67.
Related terms
- Sortino ratioLike the Sharpe ratio, but dividing only by downside volatility rather than all volatility.
- VolatilityHow much an investment’s returns bounce around their average — the standard measure of risk.
- Risk-free rateThe return available with essentially no risk of default, used as the baseline for every other return.
- SkewnessWhether a return distribution leans towards large gains or large losses.
- Calmar ratioAnnualised return divided by the worst drawdown — return per unit of pain.
Mentioned in
More in Measuring performance
- Survivorship bias
- Realised profit and loss
- Time-weighted return
- Real return
- Total return
- Price return
- Tracking difference
- Performance attribution
All 29 Measuring performance terms · The full glossary, 433 terms
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