What is Sharpe Ratio?
A measure of return earned per unit of total risk taken.
Formal Definition
The Sharpe ratio, developed by William Sharpe, divides a portfolio's excess return over the risk-free rate by the standard deviation of its returns. It expresses reward per unit of total volatility, allowing strategies with different risk levels to be compared. A higher Sharpe ratio indicates more efficient risk-taking; values above 1 are generally considered good.
In Simple Terms
It scores how much return you earned for the amount of stomach-churning risk you took. Two portfolios might both make 10%, but the one that got there with a smoother ride has the better score.
Example
A portfolio returning 12% with a 4% risk-free rate and 10% volatility has a Sharpe ratio of 0.8, calculated as (12 minus 4) divided by 10.