Sharpe Ratio

The Sharpe ratio, developed by economist William Sharpe, answers the question: how much extra return am I getting for the volatility I am accepting?

It is calculated by subtracting the risk-free rate, often the yield on short-term government securities, from the investment's return, and dividing the result by the standard deviation of the investment's returns.

For example, a fund with an annual return of 10%, a risk-free rate of 3% and a standard deviation of 14% has a Sharpe ratio of 0.5. Another fund returning 8% with a standard deviation of 7% has a Sharpe ratio of about 0.71, so it delivered more return per unit of risk, even though its raw return was lower.

Higher Sharpe ratios indicate better risk-adjusted performance. The ratio is widely used to compare funds, strategies and portfolios.

It has limitations. It treats upward and downward volatility the same, although investors usually worry only about losses. It assumes returns are roughly normally distributed, which may understate the risk of rare, severe losses. And like other performance measures, it depends on the period chosen.