Sharpe ratio

The Sharpe ratio answers a specific question: of the return this portfolio earned above the risk-free rate, how much per unit of volatility did it produce? Two portfolios that returned the same 8% are not equally attractive if one did it with a gently rising line and the other bounced between +30% and −15% to get there. The Sharpe ratio makes that difference numeric.

Mechanically: (portfolio return − risk-free return) / standard deviation of portfolio returns. Higher is better. A Sharpe above 1.0 is generally considered strong over long periods; above 2.0 is rare and usually reflects either a very favorable regime, a strategy that only works in calm markets, or a data artifact.

The Sharpe ratio has two well-known limitations. First, standard deviation penalizes upside volatility the same as downside — an investor who only objects to down moves might prefer the Sortino ratio instead. Second, Sharpe assumes returns are roughly normally distributed, which understates risk in strategies with fat-tailed or skewed return distributions (e.g., selling options).