Sharpe Ratio
Definition
A risk-adjusted performance measure that calculates the excess return per unit of risk, helping investors compare investments by how much return they get for the volatility they endure.
The Sharpe Ratio, developed by Nobel laureate William Sharpe, is the standard metric for evaluating risk-adjusted returns. It's calculated as: (Investment Return - Risk-Free Rate) / Standard Deviation of Returns. The higher the Sharpe Ratio, the better the return per unit of risk taken.
A Sharpe Ratio above 1.0 is generally considered good, above 2.0 is very good, and above 3.0 is excellent. The S&P 500 has historically delivered a Sharpe Ratio around 0.4-0.5 over long periods. Most hedge funds target Sharpe Ratios of 1.0 or higher.
The practical value of the Sharpe Ratio is comparing investments with different risk profiles. A fund returning 15% with high volatility might have a lower Sharpe Ratio than a fund returning 10% with low volatility. The second fund delivers better risk-adjusted returns — more return per unit of risk.
Limitations include: it treats all volatility equally (upside and downside), it assumes returns are normally distributed (crypto returns definitely aren't), and it uses historical data that may not predict the future. The Sortino Ratio, which only penalizes downside volatility, addresses the first limitation.
For portfolio construction, the Sharpe Ratio helps optimize asset allocation. Adding an asset with a low correlation to your portfolio can improve the overall Sharpe Ratio even if the individual asset's Sharpe Ratio is modest.
Where this appears in Clarity
Clarity automatically tracks and calculates these concepts across your connected accounts.
Related Terms
Frequently Asked Questions
What's a good Sharpe Ratio?
Generally: below 1.0 is subpar, 1.0-2.0 is good, 2.0-3.0 is very good, and above 3.0 is excellent (and rare for sustained periods). The S&P 500 historically has a Sharpe around 0.4-0.5. Context matters — compare Sharpe Ratios within the same asset class.
Can the Sharpe Ratio be negative?
Yes — a negative Sharpe Ratio means the investment returned less than the risk-free rate (like Treasury bills). You'd have been better off in risk-free assets. A negative Sharpe Ratio indicates the investment isn't compensating you for the risk you're taking.