Definition
The Sharpe ratio is a risk-adjusted return measure defined as the strategy's excess return over the risk-free rate divided by the standard deviation of those returns. Introduced by William Sharpe in 1966, it answers a question that raw return cannot: how much compensation did the investor receive per unit of total volatility taken on? A strategy earning 20% with wild swings can be inferior to one earning 12% with gentle drift, and the ratio captures that distinction in a single scalar.
Because the measure normalises return by risk, it is the institutional default for comparing strategies, funds, and asset classes whose volatility profiles differ. A Sharpe above 1.0 is considered respectable, above 2.0 is strong, and sustained values above 3.0 are exceptional and rare in liquid markets.
Why it matters
How it works
To compute it, take a series of periodic returns, subtract the risk-free rate from each, compute the mean and the standard deviation of the resulting excess-return series, and divide. For sub-annual return series the result is typically annualised by multiplying by the square root of the number of periods per year — sixteen for daily, roughly 3.46 for monthly. The annualisation step is where many implementations go wrong; documentation should always state the assumed frequency.
Two cautions sit on top of the formula. First, standard deviation assumes returns are roughly normally distributed; strategies with fat tails — short-vol, options-selling, momentum during regime breaks — can show a tidy Sharpe right up until the tail event arrives. Second, the ratio is path-insensitive: it does not penalise long drawdowns differently from short ones, so a strategy that lost 30% over two years and recovered will score similarly to one that lost 5% briefly. Read the Sharpe alongside maximum drawdown and the equity curve, never alone.