What is the Sharpe Ratio?
The Sharpe ratio equals (portfolio return minus risk-free rate) divided by portfolio standard deviation. If a fund returns 12% with 15% volatility and the risk-free rate is 3%, the Sharpe ratio is 0.60. A higher Sharpe ratio indicates better risk-adjusted performance. Ratios above 1.0 are considered good, above 2.0 excellent.
Using the Sharpe Ratio
The Sharpe ratio allows fair comparison between investments with different risk levels. A fund returning 8% with 10% volatility (Sharpe 0.50) is actually better risk-adjusted than one returning 15% with 25% volatility (Sharpe 0.48). The S&P 500 has historically delivered a Sharpe ratio of approximately 0.40-0.50 over long periods.
Key Considerations
The Sharpe ratio penalizes upside volatility equally with downside volatility, which may not match investor preferences. The Sortino ratio addresses this by only considering downside deviation. Sharpe ratios are also sensitive to the time period chosen - a fund may look excellent over 3 years but mediocre over 10. Always evaluate over multiple market cycles.