Return per unit of risk
Two portfolios both returned 10%. One did it smoothly; the other swung 30% in both directions along the way. The Sharpe ratio is the number that separates them, by dividing the return earned above a risk-free rate by the volatility it took to earn it.
The formula
Worked example: 10% return, 2% risk-free, 12% volatility
- Excess return: 10 − 2 = 8 points
- Sharpe ratio: 8 ÷ 12 = 0.67
Each unit of volatility bought two thirds of a unit of excess return. Whether that is good depends entirely on what else was available.
Reading the number
| Sharpe | Interpretation |
|---|---|
| Below 0 | Cash would have done better |
| 0 – 0.5 | Weak; the risk was poorly paid |
| 0.5 – 1.0 | Reasonable; broad equity markets over long periods sit here |
| 1.0 – 2.0 | Good; rare over more than a few years |
| Above 2.0 | Exceptional, or a short window, or leverage hiding something |
Same return, different Sharpe
Hold the 10% return and vary the volatility: at 6% the ratio is 1.33, at 12% it is 0.67, at 24% it is 0.33. The return did not change. The experience of holding it did, and the ratio prices that experience.
This is the whole argument for diversification. Combining assets that do not move together lowers volatility without lowering the expected return, which raises the Sharpe ratio for free.
The risk-free rate moves the answer
In 2021 the risk-free rate was near zero and the same 10% portfolio had a Sharpe near 0.83. With cash paying 4%, it falls to 0.50 on identical performance. Comparisons across years need the same benchmark rate, or they are not comparisons.
What this calculator leaves out
The shape of the returns. Standard deviation treats a sharp rise and a sharp fall as the same amount of risk; investors do not. The Sortino ratio penalises only the downside and is usually the better figure for anyone who cares which direction the volatility went.
The window changes everything
A Sharpe ratio computed over the last three years of a bull market can exceed 2.0 for a strategy that would show 0.4 over a full cycle. The ratio has no memory beyond its window.
Ask what period a quoted figure covers and whether it includes a downturn. A ratio that excludes 2008, 2020 or 2022 is describing fair weather, and the risk it measures is only the risk that happened to show up.
Leverage does not raise it
Borrowing to double a position doubles the excess return and doubles the volatility. The Sharpe ratio is unchanged. This is one of its useful properties: a levered fund cannot manufacture a better ratio, only a bigger swing.
What leverage does change is the drawdown, which the ratio does not show and which is what actually forces investors out.
Related calculators
- Sortino ratio — the same idea counting only downside volatility
- Treynor ratio — return per unit of market risk rather than total risk
- Maximum drawdown — the worst fall, which the Sharpe ratio does not show