What is Sharpe Ratio?
The Sharpe Ratio measures risk-adjusted return: how much excess return (above the risk-free rate) an investment earns per unit of total volatility. Developed by William Sharpe in 1966, it is the most widely used risk-adjusted performance metric in finance. A Sharpe Ratio above 1.0 is considered good; above 2.0 is excellent; above 3.0 is exceptional and often unsustainable. The ratio penalises both upside and downside volatility equally, which is a limitation; the Sortino Ratio addresses this by using only downside deviation. A strategy with a high Sharpe Ratio in a bull market may have a very different Sharpe in a bear market.
Formula
Sharpe Ratio = (Portfolio Return − Risk-Free Rate) / Portfolio Standard Deviation
Portfolio Return = annualised return (%)
Risk-Free Rate = annualised T-bill yield (%)
Standard Deviation = annualised volatility of returns (%)
Calculator
How to Use
- 1Calculate annualised return: Total return over the period, annualised. For monthly returns, annualise as (1+r)^12 − 1.
- 2Subtract the risk-free rate: Use the 3-month T-bill rate annualised over the same period.
- 3Divide by annualised standard deviation: The standard deviation of return series, annualised (multiply monthly StdDev by √12).
- 4Interpret: >1 is good, >2 is excellent. Compare strategies on the same time period to make valid comparisons.
Worked Example
Example: Equity fund
Portfolio Return
14%
Risk-Free Rate
5%
Std Dev
12%
Sharpe = (14% − 5%) / 12% = 0.75. Below 1.0: the fund earns less than one unit of excess return per unit of risk. An index fund returning 12% with 15% volatility would have Sharpe = (12%-5%)/15% = 0.47, which is worse. So the fund beats the index on a risk-adjusted basis despite lower absolute return if its volatility is lower.