What Is the Sharpe Ratio?
The Sharpe ratio measures the attractiveness of a risky investment by comparing its excess return (above a risk-free rate) to its volatility. In other words, it tells you how much extra return you earn for every unit of risk taken. A higher Sharpe ratio means better risk-adjusted performance.
The concept is closely connected to the Capital Asset Pricing Model (CAPM), which helps determine the expected return of an asset based on its inherent risk level.
Sharpe Ratio Formula
The Sharpe ratio formula is:
Risk Premium = Ra − Rf
Where:
- Ra — Return of the asset or portfolio (%).
- Rf — Risk-free rate of return (e.g., yield on government bonds) (%).
- σ (sigma) — Standard deviation of the asset's returns, measuring volatility.
- Risk Premium — The additional return an investor requires for holding a risky asset instead of a risk-free one.
Understanding Standard Deviation (σ)
Standard deviation measures the spread of possible returns around the expected value. A risky asset can produce many different outcomes; the standard deviation quantifies how wide that spread is.
Consider two investments, both with an expected return of 10%:
- Investment A: Standard deviation = 15% (wide spread — higher risk)
- Investment B: Standard deviation = 7.5% (narrow spread — lower risk)
Most investors prefer Investment B over A because the same expected return comes with less uncertainty. However, if a third investment C offers 20% return with the same standard deviation as B (7.5%), most investors will prefer C — higher return, same risk.
How to Interpret the Sharpe Ratio
| Sharpe Ratio | Interpretation |
|---|---|
| Below 0 | Negative — investment performs worse than the risk-free rate |
| 0 to 0.99 | Below Average — suboptimal risk-adjusted return |
| 1.0 to 1.99 | Good — acceptable risk-adjusted performance |
| 2.0 to 2.99 | Very Good — strong risk-adjusted return |
| 3.0 and above | Excellent — outstanding risk-adjusted performance |
Practical Example
Suppose a stock portfolio has an annual return of 12%, the current risk-free rate (10-year Treasury yield) is 3%, and the portfolio's standard deviation is 15%:
Sharpe Ratio = 9% / 15% = 0.60
A Sharpe ratio of 0.60 is below average. The investor earns only 0.60 units of return per unit of risk — it may be worth comparing against alternative investments.
Portfolio Diversification and Risk
Diversification reduces the standard deviation of a portfolio without proportionally reducing its expected return. If you hold 40% in Stock A (expected return 10%, σ = 20%) and 60% in Stock B (expected return 15%, σ = 12%), the blended expected return is a weighted average, but the portfolio's standard deviation is lower than the weighted average of individual deviations — thanks to diversification.
This is why the Sharpe ratio often improves with a well-diversified portfolio: lower overall volatility with similar expected returns means a better ratio.
Number Format and Currencies
This calculator supports two number formats:
- American — thousands separator comma, decimal period: 1,234.56
- Metric (European) — thousands separator period, decimal comma: 1.234,56
When providing a portfolio value, you can choose from 25 world currencies, including USD, RUB (₽), EUR, GBP, JPY, and many others. The monetary impact section then shows your expected return, risk-free return, and risk premium in the selected currency.
Limitations of the Sharpe Ratio
- It assumes returns are normally distributed, which may not hold in practice.
- It uses historical standard deviation, which may not predict future risk.
- Strategies that artificially reduce measured volatility (e.g., certain options strategies) can show inflated Sharpe ratios.
- It is most useful when comparing similar assets or portfolios over the same time period.