Sharpe ratio divides average excess return by return volatility. It is useful for comparing risk-adjusted performance over the same window, but it assumes volatility is a meaningful risk proxy and can be distorted by non-normal returns, short samples and changing regimes.
Transparent formula
Sharpe ratio = (average return − risk-free return) ÷ return standard deviation
Worked example
If annualized return is 30%, the risk-free rate is 4% and annualized volatility is 65%, the simplified Sharpe ratio is about 0.40. The same return over a quieter period would produce a higher ratio.
Use this sequence
- Choose return frequency and window.
- Use a consistent risk-free rate.
- Annualize return and volatility consistently.
- Compare with drawdown and Sortino ratio.
Common mistakes
- Comparing ratios from different windows.
- Ignoring large drawdowns.
- Treating volatility as the only risk.
Verify next
Frequently asked questions
Is a higher Sharpe always better?
Within a consistent comparison it indicates more return per unit of volatility, but data quality and strategy risks still matter.
Why use Sortino too?
Sortino focuses on downside volatility and can better reflect asymmetric return distributions.
Can a negative Sharpe be meaningful?
Yes. It indicates return below the selected risk-free benchmark over the measured window.
This page provides calculation and research frameworks, not investment, legal or tax advice.
