Sharpe ratio

Investing glossary · Risk and statistics

The excess return over a risk-free rate, divided by volatility: how much return you earn for each unit of risk.

Definition

The Sharpe ratio measures risk-adjusted return. It subtracts the return of a risk-free asset (such as short-term government bills) from the portfolio's return, and divides by the portfolio's volatility. The higher the ratio, the more return you earned for each unit of risk.

It lets you compare investments that took different amounts of risk: a portfolio that earned more may simply have taken much more risk. The Sharpe ratio has limits: it treats upside and downside volatility alike, it depends on the period measured, and it can be flattered by strategies that hide rare large losses.

Formula

Sharpe = (R_portfolio − R_risk-free) ÷ σ_portfolio

R_portfolio = annual return, R_risk-free = risk-free rate, σ_portfolio = annual volatility of the portfolio.

Worked example

Illustrative numbers

Assume a risk-free rate of 3%. Portfolio A returned 9% with 12% volatility: Sharpe = (9% − 3%) ÷ 12% = 0.50. Portfolio B returned 14% with 25% volatility: Sharpe = 0.44. B earned more in absolute terms, but A earned more per unit of risk.

These numbers are illustrative, chosen to show why the highest return is not automatically the best risk-adjusted result.

How ATLAS uses it

ATLAS ranks and describes portfolios by their return and risk together; in university challenges, the "best risk-adjusted return" is one of the prizes.

Frequently asked questions

What is a good Sharpe ratio?

Around 1 is generally considered good, above 2 is excellent, and below 1 is modest. Compare it with a relevant benchmark over the same period.

What are the limits of the Sharpe ratio?

It uses total volatility (up and down), assumes returns are roughly bell-shaped and depends on the measured period, so it should not be the only measure.

Related terms

Put the idea to work on your own stocks

Open any company in ATLAS to see its fair value, its odds of rising and its risk numbers side by side.

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Not investment advice. ATLAS estimates are produced by statistical models from public data; they can be wrong and past performance does not predict future results. Consider your own situation before investing. Disclaimer