What is Sharpe Ratio?
The Sharpe Ratio is a financial metric that measures the risk-adjusted return of an investment, showing how much excess return (profit above the risk-free rate) you earn for each unit of risk (volatility) taken. A higher Sharpe Ratio indicates a more efficient investment — better returns relative to the risk endured.
The Sharpe Ratio is calculated as (R − Rf) / σ, measuring excess return above the risk-free rate divided by volatility, quantifying efficiency of risk-taking.
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Step-by-step worked examples
Portfolio A returns 14%, risk-free rate 2%, volatility 15%. Calculate Sharpe Ratio.
Excess return = R − Rf = 14% − 2% = 12% Sharpe = 12% / 15% = 0.80 For every 1% of risk, the portfolio returns 0.80% above risk-free.
Portfolio B returns 10%, risk-free 2.5%, volatility 8%. Which has higher Sharpe — A or B?
Portfolio A: 0.80 (from above) Portfolio B: (10% − 2.5%) / 8% = 7.5% / 8% = 0.9375 Portfolio B has higher Sharpe Ratio (0.94 > 0.80) despite lower absolute return.
An aggressive fund returns 25%, risk-free 3%, volatility 40%. Conservative fund returns 8%, risk-free 3%, volatility 5%. Compare.
Aggressive: (25% − 3%) / 40% = 22% / 40% = 0.55 Conservative: (8% − 3%) / 5% = 5% / 5% = 1.00 Conservative has better risk-adjusted return (Sharpe = 1.00 > 0.55).
Flashcards
Quick quiz
Q1.Portfolio returns 16%, risk-free 3%, volatility 20%. Sharpe Ratio?
Q2.Two portfolios: A has Sharpe 1.2, B has Sharpe 0.9. What does this mean?
Q3.If risk-free rate increases, Sharpe Ratio…
Q4.A portfolio has high return but also very high volatility. Its Sharpe might be…
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Common mistakes
A portfolio with high return always has high Sharpe Ratio. — Correct: Sharpe also depends on risk — a high-return portfolio with very high volatility may have lower Sharpe than a balanced portfolio.
Sharpe Ratio is the same for all investors. — Correct: Sharpe depends on the risk-free rate, which varies over time and by investor (e.g., US Treasury yields change daily).
You should always maximize Sharpe Ratio. — Correct: Higher Sharpe is generally better, but personal goals (time horizon, risk tolerance) matter — not all investors need maximum Sharpe.
Negative Sharpe Ratio means the portfolio loses money. — Correct: Negative Sharpe means return is below risk-free rate (underperforming bonds) — the portfolio may still gain absolute return.
FAQ
What is Sharpe ratio?
Sharpe ratio = (R − Rf) / σ measures how much excess return you earn per unit of risk — a key metric for comparing risk-adjusted performance.
What is a good Sharpe ratio?
Sharpe > 1.0 is considered good, > 2.0 is very good, > 3.0 is excellent. Context (asset type, time period) matters.
Why use risk-free rate in Sharpe?
Risk-free rate (bonds) is the minimum return for zero risk — excess return shows your reward for taking extra risk.
Can you use Sharpe to compare all investments?
Yes — Sharpe compares stocks, funds, crypto, any asset — higher Sharpe indicates better risk-adjusted efficiency.