What is Sharpe Ratio?
The Sharpe ratio measures risk-adjusted returns by dividing the excess return of a portfolio (above the risk-free rate) by its standard deviation, indicating how much return you're getting per unit of risk.
Sharpe Ratio Explained
A higher Sharpe ratio means more return for the risk taken. A ratio above 1.0 is good, above 2.0 is excellent, and above 3.0 is outstanding. A strategy with high returns but wild swings (high standard deviation) will have a lower Sharpe ratio than a steadier strategy with similar returns. Institutional investors prioritize Sharpe ratio when evaluating strategies.
Real-World Example
Strategy A returns 30% with 20% volatility. Strategy B returns 20% with 8% volatility. Assuming 5% risk-free rate, Strategy A's Sharpe is 1.25 while Strategy B's Sharpe is 1.875. Strategy B is more efficient — better return per unit of risk.
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